Chapter 1 Overwiew of Financial Management.pptx

Overwiew of Financial Management.pptx

1. Chapter 1 Overview of Financial Management Areas of Finance Forms of Businesses Goals of Financial Managers Conflicts Between Managers and Shareholders Business Ethics 1

2. What we learn in this chapter… The basic types of financial management decisions and the role of the financial manager. The goal of financial management. The financial implications of the different forms of business organization. The conflicts of interest that can arise between owners and managers. 5

3. Finance The science or study of the management of funds —Merriam Webster Dictionary Four main areas of financial study: Corporate finance Investments Financial institutions (Banks, insurance, …) International finance (outsourcing, banks loans across countries, any business overseas operations) 3

4. Why is studying finance important? 4 Marketing Accounting Human Resources Operations/Logistics Information Technology Management Personal finance

5. Corporate Finance & the Financial Manager Some important questions that are addressed in the corporate finance world: What long-term investments should the firm take on? Where will the firm get the long-term financing to pay for the investments? How will the firm manage everyday financial activities ? 5

6. Financial Management Decisions Capital budgeting What long-term investments or projects should the business take on? Capital structure Where will the firm get the long-term financing to pay for the investments? Should we use debt or equity? Working capital management How do we manage the day-to-day finances of the firm? 6

7. Forms of Business Organization Sole Proprietorship — unincorporated business owned by an individual Partnership — unincorporated business owned by two or more individuals Corporation — a legal entity created by a state to do business; separate and distinct from its owners and managers LLC & LLP —hybrids between partnerships and corporations 7

8. Forms of Business—Prevalence Number of firms 80% are sole proprietorships 10% are partnerships 10% are corporations Dollar value of sales 80% by corporations 13% by sole proprietorships 7% by partnerships 8

9. Proprietorships & Partnerships Advantages Ease of formation Subject to few regulations No corporate income taxes Disadvantages Unlimited liability Difficult to raise capital Limited life Difficult to transfer ownership 9

10. Corporation Advantages Limited liability Ease of raising capital Easy transfer of ownership Unlimited life Disadvantages Double taxation Cost of set-up and report filing Agency problem 10 More on this later!

11. Corporation Stakeholders Stakeholder—anyone who is impacted by, or has an interest in, a corporation. Some of these stakeholders have conflicting interests .( banks vs shareholder vs government ) So in whose interest should a corporation operate? 12

12. A Manager’s Goal Shareholder wealth maximization! A manager should try to maximize the value of the firm’s stock, subject to certain constraints. Do firms have any responsibilities to society at large? Is stock price maximization good or bad for society? 12

13. Practice Question Which of the following statements is CORRECT? A hostile takeover is the main method of transferring ownership interest in a corporation. A corporation is a legal entity created by a state, and it has a life and existence that is separate from the lives and existence of its owners and managers. Unlimited liability and limited life are two key advantages of the corporate form over other forms of business organization. Limited liability is an advantage of the corporate form of organization to its owners ( stockholders). 13

14. Practice Question Which of the following could explain why a business might choose to operate as a corporation rather than as a sole proprietorship or a partnership? Corporations generally face fewer regulations. Less of a corporation’s income is generally subject to taxes. Corporate investors are exposed to unlimited liability. Corporations generally find it easier to raise capital. 14

15. The Agency Problem Agency relationship Principal hires an agent to represent its interests Stockholders (principals) hire managers (agents) to run the company Agency problem Conflict of interest between principal and agent This problem arises due to the separation of ownership and control . (Carlos Ghosn ) 15

16. Conflicts Between Managers and Stockholders Managers (and people in general) are naturally inclined to act in their own best interests (which are not always the same as the interests of stockholders). But the following factors affect managerial behavior: Managerial compensation plans The threat of firing 16

17. Mitigating the Principal-Agent Problem Offer managers compensation plans that are tied to long-term stock performance Shares of company stock Stock options maturing over a number of years Bonuses based on stock performance 17

18. Mitigating the Principal-Agent Problem Most managers want to keep their jobs. Proxy fight Takeovers (CEO normally tries to avoid a potential takeover) Large shareholders 18

19. Practice Question Will the following actions reduce or increase conflicts of interest between stockholders and managers? Congress passes a law that severely restricts hostile takeovers, thereby reducing the probability that a management team will be replaced. Managerial compensation is changed so that managers receive larger cash salaries but fewer shares of stock. The board of directors allow managers greater freedom of action. A requirement that members of the board of directors have a substantial investment in the firm’s stock is instituted. 19

20. Business Ethics Business ethics: a company’s attitude and conduct toward its employees, customers, community and stockholders Some examples of unethical behavior? 20

21. Ethics Legislation Sarbanes-Oxley Act of 2002 The CEO and CFO are personally and directly responsible for the accuracy of financial statements. Companies are required to immediately disclose any material changes in their financial situations. Companies must maintain “an adequate internal control structure and procedures for financial reporting”. Knowingly destroying documents to hide material, adverse information is now a felony punishable by up to 20 years in prison. “Whistle-blower” protection: an employee can’t be fired for reporting wrongdoing by superiors. 21

22. Enron Corp US energy company—oil, gas, water, and more—based in Houston, Texas, 1985-2001. Used accounting fraud and off-balance-sheet derivatives to artificially inflate profitability and hide its deteriorating financial condition. Employed around 21,000 people, most of whom lost their retirement savings, college funds, and pensions when the firm went bankrupt. $2 billion in pension plans were wiped out. 22

23. Enron Corp Enron and Anderson executives were charged with: Bank fraud Securities fraud Wire fraud Money laundering Insider trading Conspiracy Obstruction of justice 23

24. Enron Corp Scandal Feb 12, 2001 —Jeff Skilling becomes Enron CEO; Ken Lay stays on as chairman [$79.80/share] Aug 15, 2001 —Lay receives warning letter from Sherron Watkins [$40.25/share] Aug 20-21, 2001 —Lay sells 93,000 Enron shares for $2 million; urges employees to buy Enron stock [$36.88/share] Oct 16, 2001 —Enron reveals $1.2 billion decrease in firm value [$33.84/share] Nov 9, 2001 —Email sent telling secretaries to “stop the shredding” [$8.63/share] Dec 2, 2001 —Enron files for bankruptcy [$0.40/share] Jan 15, 2002 —Enron suspended from New York Stock Exchange [$0.00/share] 24

25. Enron Corp Scandal 25

26. Enron Corp Scandal— What Happened? 1996-2001: Named “America’s Most Innovative Company” by FORTUNE magazine December 2001: Enron became America’s largest corporate bankruptcy to date; liquidated July 2006: Lay dies of heart attack; therefore conviction thrown out; had faced up to 45 years in prison September 2006: CFO sentenced to 6 years in prison (released in 2011) October 2006: Skilling sentenced to 24 years in prison (released in 2019) 26

27. Financial Market Classifications Primary vs. Secondary Markets Primary markets are where firms issue new stock or bonds to investors Initial Public Offering Seasoned Equity Offering Secondary markets are where investors trade already-issued stocks or bonds with each other NYSE NASDAQ 27

28. Practice Question Apple Computer decides to issue additional stock with the assistance of its investment banker. An investor purchases some of the newly issued shares from the investment banker. Is this a primary market transaction or a secondary market transaction? What if instead an investor buys existing shares of Apple stock in the open market – is this a primary or secondary market transaction? 28

29. Practice Question The primary operating goal of a publicly-owned firm interested in serving its stockholders should be to: Maximize its expected total corporate income. Maximize its expected EPS. Minimize the chances of losses. Maximize the stock price per share. 29