Module One

Jackie Channn

Chapter1TheFinancialManagerandtheFirm.pdf

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Fundamentals of Corporate Finance Fourth Edition

Robert Parrino, Ph.D.; David S. Kidwell, Ph.D.; Thomas W. Bates, Ph.D.; Stuart Gillan, Ph.D.

Chapter 1

The Financial Manager and the Firm

Chapter 1: The Financial Manager and the Firm

Learning Objectives

1. Identify the key financial decisions facing the financial manager of any business

2. Identify common forms of business organization in the United States and their respective strengths and weaknesses

3. Describe the typical organization of the financial function in a large corporation

4. Explain why maximizing the value of the firm’s stock is the appropriate goal for management

5. Discuss how agency conflicts affect the goal of maximizing stockholder value

6. Explain why ethics is an appropriate topic in the study of corporate finance

The Role of the Financial Manager (1 of 2)

• Maximize Shareholder Wealth

o Maximizing the price of a firm’s stock will maximize the value of a firm and the wealth of its shareholders/owners

• Stakeholders

o Managers, employees, suppliers, creditors, and the government

The Role of the Financial Manager (2 of 2)

• It’s All About Cash Flows

o Positive residual cash flow may be paid to firm owners as dividends or invested in the firm

o The larger the positive residual cash flow, the greater the value of a firm

o Negative residual cash flow, over the long run, leads to bankruptcy or closing a business

The Role of the Financial Manager

• Three Fundamental Decisions in Financial Management

o Capital Budgeting: identify which long-term assets to acquire to maximize net benefits for the firm

o Financing: determine how to pay for short-term and long-term assets by finding the best combination of short-term debt, long-term debt, and equity

o Working Capital: decide how to manage short-term resources and obligations by adjusting current assets and current liabilities to promote growth in cash flow

• Poor decisions about capital budgeting, financing, or working capital may lead to bankruptcy or business failure

Forms of Business Organization

• Sole proprietorships

• Partnerships

• Corporations

Sole Proprietorship

• Owned by a single person who is financially responsible for the actions and obligations of the business

• Advantages

o Easiest to create and control

o Easiest to dissolve

o Right to all profits

• Disadvantages

o Owner’s personal assets at risk due to unlimited liability for firm obligations

o Equity only from owner or business profit

o Business income taxes as personal income

o Difficult to transfer ownership

Partnership

• A business owned by more than one person; one or more of them is financially responsible for the actions and obligations of the business

• Advantages

o Limited protection of owner’s personal assets

o Owner’s limited liability for firm obligations

o More sources of equity

o More sources of expertise

• Disadvantages

o Shared control

o Shared profit harder to dissolve

Corporation • A business owned by more than one person; none of them are financially

responsible for the actions and obligations of the business. The corporation is responsible for its obligations and actions.

• Advantages

o Protects personal assets

o No shareholder liability for business

o Easiest to change ownership

o Greatest access to sources of funds

• Disadvantages

o Most difficult and expensive to establish

o Dilutes individual control over the firm

o Overall higher taxes on income for shareholders

Hybrid Forms of Business Organization

• Limited Liability Partnerships (LLPs)

• Limited Liability Companies (LLCs)

• Both combine limited liability with tax advantages of a partnership

Managing the Financial Function

• Organizational Structure

o Chief Financial Officer (CFO), responsible for the quality of the financial reports received by the Chief Executive Officer (CEO)

o Positions Reporting to the CFO

• Treasurer

• Risk Manager

• Controller

• Internal Auditor

o External Auditor

o Audit Committee

o Compliance and Ethics Director

The Goal of the Firm

• Why not maximize market share?

o Giving away goods or services for free will maximize a firm’s market share for a while, but the firm will not be able to pay its bills and stay in business

• Why not maximize profits?

o Accounting profit differs from economic profit

o Profit earned may not equal cash received

• Maximize the value of the firm’s stock

o Future cash flows are considered

o The timing of future cash flows is considered

o The risks associated with having to wait to for cash flows are considered

• Management decisions affect cash flows and therefore stock prices

Agency Relationship

• An agency relationship is created when the owner (a principal) of a business hires an employee (an agent)

• The owner surrenders some control over the enterprise and its resources to the employee

• Separating ownership from control creates the potential for agency conflicts

Agency Conflicts

• An agency relationship exists between stockholders (principals) and the firm’s hired management (agents)

• Ownership and Control

o In large corporations, shared ownership among many shareholders may result in relatively little control over management

o Shareholders own the corporation, but managers control the firm’s assets and may use them for their own benefit

Agency Costs

• Agency Costs are costs that arise from incurring and preventing conflicts of interest between a firm’s owners and its managers

• These costs may reduce positive residual cash flow, stock price, and shareholder wealth

• Agency costs can be reduced by

o Increased oversight

o Aligning incentives

• Giving agents the right incentives to reduce agency costs

o Managers tend to focus on wealth maximization when their compensation depends on stock price

Aligning the Interests of Managers and Stockholders • Board of Directors has oversight over the CEO and

major capital decisions

• Managerial labor market provides incentives to run the company well

• Internal competition among managers

• Large stockholders also monitor managerial decisions

• Corporate raiders search for takeover targets

• Legal and regulatory constraints limit managerial behavior

Sarbanes-Oxley and Regulatory Reform (1 of 2) • Better corporate governance reduces agency costs by

requiring

o More effective monitoring of managers’ activities

o Programs that promote appropriate behavior by managers

o Penalties for executives who do not fulfill their fiduciary responsibilities

Sarbanes-Oxley and Regulatory Reform (2 of 2) • The new regulations require all public corporations to

implement the following strategies:

o Ensure greater board independence

o Establish internal accounting controls

o Establish compliance programs

o Establish an ethics program

o Expand the audit committee’s oversight powers

The Importance of Ethics in Business

• What are Ethics?

o Ethics are society’s standards for judging whether an action is right or wrong

o Business Ethics are society’s standards for acceptable behavior applied to business and financial markets

Ethics in Corporate Finance (1 of 2)

• Examples of Ethical Conflict in Business

o Agency Cost

• Employee’s unacceptable use of employer’s computer

• Conflict of Interest

o Mortgage contract which a home-buyer is unlikely to fulfill but earns a mortgage broker more money–

• Information Asymmetry

o Seller knows about prior damage to the vehicle but the potential buyer does not

Ethics in Corporate Finance (2 of 2) • Business Behavior

o Regulation and market forces are not enough to maintain integrity in the marketplace

o Business norms must be based on ethical beliefs, customs, and practices

• Ethical Behavior

o It is sometimes difficult to judge whether behavior is ethical or not

• Was the manager too careful?

• Did the manager take too much risk?

• Consequences of Unethical Behavior

o Inefficiency in the economy and costs to society

o High legal and social costs

o Problems such as the recent financial crisis in the U.S.

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