Ch01 Revised

8/3/2019 Ch01 Revised

1/29

1Chapter 1 The Financial Manager and the Firm Copyright 2008 John Wiley & Sons

CHAPTER 1

The Financial Manager and the Firm


2/29


Learning Objectives

1. Identify the key financial decisions facing the financialmanager of any business firm.

2. Identify the basic forms of business, and review theirrespective strengths and weaknesses.

3. Describe the typical organization of the financialfunction in a large corporation.

4. Explain why maximizing the current value of the firms

stock price is the appropriate goal for management.

5. Discuss how agency conflicts affect the goal of

maximizing stockholder wealth.6. Explain why ethics is an appropriate topic in the study

of corporate finance.


3/29


Exhibit 1.1: Cash Flow Diagram


4/29


Three Fundamental Decisions in Financial Management

1. The capital budgeting decision: Which productive assetsshould the firm buy?

A good capital budgeting decision is one in which the benefits areworth more for the firm than the cost of the assets.

2. The financing decision:How should the firm finance orpay for assets?

Financing decisions involve trade-offs between advantages and

disadvantages of debt and equity financing.

3. Working capital management decisions:How shouldday-to-day financial matters be managed?

The mismanagement of working capital can cause the firm to go

into bankruptcy even though the firm is profitable.

The Role of the Financial Manager


5/29


Exhibit 1.2: How Financial Managers Decisions

Affect the Balance Sheet


6/29


Legal Forms of Business Organizations

Sole Proprietorship

Partnership

CorporationHybrid Forms


7/29



Sole ProprietorshipBusiness owned by one person

No legal distinction between personal and business income for asole proprietor;

All business income is taxed as personal income;

A sole proprietorship has unlimited liability for all business debts

and other obligations of the firm.

Advantages

Disadvantages


8/29


Partnership

Consists of two or more owners joined togetherlegally to manage a business;

When a transfer of ownership takes place, the

partnership is terminated and a new partnershipis formed;

The problem of unlimited liability can be avoidedin a limited partnership;

Has the same basic advantages anddisadvantages as a sole proprietorship.



9/29


Corporation Legal entities authorized under a state charter;

In a legal sense, it is a person distinct from itsowners;

The owners of a corporation are its stockholders, orshareholders. Public corporations can sell their debtor equity in the public securities markets;

Private corporations are held by a small number of

investors.



10/29


Corporation

Advantages:

Access to the public securities markets, whichmakes it easier to raise large amounts of capital,and the ease of ownership transfer;

Stockholders have limited liability.

Disadvantage:

Owners are subject to double taxation, first at the

corporate level and then at the personal level whendividends are paid to them;



11/29


Hybrid Forms of Business Organization

Limited liability partnerships (LLPs)combine the limited liability of a corporation

with the tax advantage of a partnership.

Limited liability companies (LLCs)

Professional corporations (PCs)



12/29


Financial Function

Chief Executive Officer (CEO)

Ultimate management responsibility anddecision-making power in the firm.

Reports directly to the board of directors, whichis accountable to the companys owners.


13/29


Chief Financial Officer (CFO): Responsible for the

best possible financial analysis that is presented to theCEO.

Positions that report to the CFO:

- The Controllerprepares financial statements, oversees the firms

cost accounting systems, prepares taxes

- The Treasurer looks after the collection and disbursement ofcash, invests excess cash, raises new capital, handles foreign

exchange, and oversees the firms pension fund managers.

- The Internal Auditor is responsible for in-depth riskassessments, performing audits of high-risk areas.

- The Risk Manager manages the firms risk exposure in financialmarkets and the relationships with insurance providers.

Financial Function


14/29


External Auditors Provide an independent annual audit of the firms financial

statements.

Ensure that the financial numbers are reasonably accurate, and

accounting principles have been consistently applied.

Audit Committee Approves the external auditors fees and engagement letter. The

external auditor cannot be fired or terminated without the auditcommittees approval.

Compliance and Ethics Director Oversees the compliance program, ethics program, and the

compliance hotline and reports directly to the audit committee.

Managing the Financial Function


15/29


Exhibit 1.3: Simplified Corporate Organization Chart


16/29


The Goal of the Firm

What the goal of the firm should be?

Why not maximize profits? With creative accounting the firm can manipulate the profit

figures.

Accounting profits are not necessarily the same as cash flows.

Profit maximization does not tell us when cash flows are to bereceived.

Profit maximization ignores the uncertainty or risk associated

with cash flows.

Maximize profit /revenue / assets? Minimizing risks?

What else?


17/29



Maximize the Value of the Firms Stock Price

When analysts and investors determine thevalue of a firms stock, they consider:

The size of the expected cash flows.

The mechanism for determining stock pricesovercomes all the cash-flow objectionsraised.

The timing of the cash flows.

The riskiness of the cash flows.


18/29



Maximize the Value of the Firms Stock Price

An appropriate goal for financialmanagement is to maximize the currentvalue of the firms stock.

For private corporations and

partnerships, the goal is to maximize thecurrent value of owners equity.


19/29


Exhibit 1.4: Major Factors Affecting

Stock Prices


20/29



Can Management Decisions Affect Stock Prices?

YES!!!

Then, HOW?


21/29


Agency Conflicts:

Separation of Ownership and Control

Ownership and Control

For large corporations, the ownership of the firmis spread over huge number of shareholders and

the firms owners may effectively have littlecontrol over management .

Management may make decisions that benefittheir self-interest rather than those of thestockholders.


22/29


Agency Relationships

An agency relationship arises whenever oneparty, called the principal, hires another party,

called the agent.

Agency Conflicts:


The relationship between stockholders(principals) and management (agents) is anagency relationship.


23/29


Do Managers Really Want to Maximize Stock Price?

Shareholders own the corporation, but managerscontrol the money and have the opportunity touse it for their own benefit.

Agency Costs

Agency Conflicts:


The costs of the conflict of interest between the

firms owners and its management.


24/29


How can agency conflicts be reduced in a corporation?

Aligning the Interests of Management andStockholders

Main mechanisms: management compensation,and the board of directors:

1. Management Compensation

A significant portion of management

compensation should be tied to firmperformance (e.g. stock price).

Agency Conflicts:



25/29


2. Board of Directors Lack of board independence is a key factor in

the misalignment between board members

and stockholders interests

Agency Conflicts:


Other Managers

Large Stockholders

The Takeover Market

The Legal and Regulatory Environment


26/29


The Importance of Ethics in Business

A societys ideas about what actions areright and wrong.

Are Business Ethics Different?

Business Ethics

Traditions of morality are relevant to businessand financial markets.

Corruption in business creates inefficienciesin an economy.


27/29


Types of Ethical Conflicts in Business

Conflicts of Interest

Conflict between individuals personal or

institutional gain and the obligation toserve the interest of another party.

Information Asymmetry

One party in a transaction hasinformation that is unavailable to theother parties.


Agency Costs


28/29


The Importance of and Ethical Business Culture

Ethicists argue that laws and market forcesare not enough.

Serious Consequences

Legal cost of ethical mistakes can be

extremely high.



29/29


Exhibit 1.6: A Framework for the

Analysis of Ethical Conflicts

Documents

Ch01 Revised