principles of finance
finance:
- study of how people and businesses evaluate investments and raise capital to
fund them
basic questions addressed by finance:
- capital budgeting
- which long-term investments should a firm undertake?
- “of all the opportunities that we have, which is the best?”
- capital structure
- how should the firm pay for these investments?
- what is the best combination of short term debt, long term debt, and
equity?
- “what is the best way to pay for stuff?”
- working capital management
- how can the firm best manage its cash flows from day to day operations?
3 major forms of business organization
- sole proprietorship
- owned by one person who is responsible for actions/obligations of
business
- advantages:
- easiest to create/dissolve
- owner has all control rights
- owner has all cash flow rights
- no other partners need to be consulted
- business income taxed only one as personal income
- disadvantages:
- no legal separation between business and owner
- unlimited personal liability for firm obligations
- limited sources of expertise
- difficult to raise new equity
- difficult to transfer ownership
- difficult to know value of the business
- partnership (general or limited)
- owned by more than one person, one or more being responsible for
actions/obligations of the business
- advantages:
- limited partners have limited liability
- more sources of equity financing
- more sources of business expertise
- disadvantages:
- may require a legal contract to form
- shared control
- shared profit
- harder to dissolve
- corporation
- owned by one or more than one person, none responsible for the actions
and obligations of the business
- corporation itself is responsible for its own actions/obligations
- corporations can sue/be sued and purchase/sell property
- owners of corporation are stockholders
- stockholders vote on a board of directors to represent them
- advantages
- no stockholder liability for business obligations
- unlimited life (thomas edison founded General Electric)
- easy to change ownership
- greatest access to sources of capital
- disadvantages
- most difficult and expensive to establish
- dilutes individual control over the firm
- separation of owners and managers leads to agency costs
- double taxation
Suppose a corporation earns USD 8.00 per share in net income. Suppose the corporate
income tax rate is 25 percent and the tax rate on personal dividend income is 20
percent. How much will a stockholder receive after all the taxes are paid?
Suppose a corporation earns USD 8.00 per share in net income. Suppose the corporate
income tax rate is 25 percent and the the tax rate on personal dividend income is 20
percent. What is the total tax rate?
hybrid organizations
- s-corporations
- limited liability companies
- both combine limited liability with tax advantages of a partnership
financial manager decisions
- capital budgeting
- capital structure
- working capital management
financial manager goal: make decisions that maximize market value of firm’s stock
- this maximizes wealth of stockholders
- running firm efficiently
- offering a product customers voluntarily buy
- treating employees and suppliers well
- legally minimizing tax payments
- following all accounting rules and regulations
- paying loans on time with little interest as possible
why not maximize market share?
- giving away goods or services for free will maximize market share
- but firms won’t be able to pay bills and stay in business
why not maximize profits?
- accounting profit differs from economic profit
- accounting net income may not equal cash flow
do manager’s decisions affect stock prices?
- yes but also affected by outside factors
- taxes, regulations, consumer sentiment, monetary policy and inflation
systematic risks: risks out of management’s control
- economic shocks
- business environment
non-systematic risks
- firm-specific risks affected by management
all about cash flow
- cash is king
- stockholders receive residual cash flow
- residual cash flow may be paid out as dividends or reinvested in the firm
- larger residual cash flow, greater value of the firm
- negative residual cash flow can lead to bankruptcy
cash flow and stock prices
- size: more is better than less
- timing: sooner is better than later
- riskiness: less risky is better than more risky
what is an agency relationship
- stockholders are the principals
- managers are the agents
- agency relationship arises when principal hires agent
- stockholders surrender some control over the enterprise and its resources to the
mangers
- separating ownership from control creates potential for agency conflicts
- shared ownership among many stockholders may result in relatively little control
over management
- stockholders own corporation but managers control firm’s assets and may use
them for own benefit
- ex: large compensation and bonuses, useless mergers/acquisitions, private jets,
donations to charity, fine art on the walls, etc.
Suppose a manager who owns one percent of the firm’s stock decides to spend USD
100,000 on an unnecessary office upgrade. How much does the manager benefit from
the office upgrade? How much does the office upgrade cost the manager?
Examples of agency problems
– Excess risk taking
– Ill-advised mergers and acquisitions
– Retaining excess free cash flow
– Excessive office space and decorations
– Corporate meals and travel expenses
– Nepotism
– High pay
– Lavish benefits
– Private jets
– Adopting anti-takeover measures like poison pills
what are agency costs
- costs that arise form incurring and preventing conflicts of interest between a
firm’s owners and its mangers
- these costs may reduce residual cash flow, stock price, and stockholder wealth
how to mitigate agency problems?
- increased oversight by board of directors
- giving agents the right incentives to reduce agency costs
- managers tend to focus on wealth maximization when their compensation
depends on stock price
- laws and regulations
- career concerns
- threat of takeover
Remedies for the agency problem
– Monitoring by the Board of Directors
– Legal and regulatory environment
– Incentive contracts
– Concentrated ownership
– Debt
– Overseas stock listings
– The market for corporate control
– Mangers’ reputation and future job prospects
giving incentives example:
suppose a company’s ceo has the option to buy 2.5 million
shares for usd 1.15 per share at any time beginning one year
from today. the firm’s stock currently trades at usd 0.95
per share. what is the total value of this stock option if if
the stock price rises to usd 3.15?
- option value per share = 3.15 - 1.15 = 2.00
- total value = 2.00 x 2,500,000 = 5,000,000
laws and regulations examples:
- sarbanes-oxley act forces managers to do certain tasks
- includes penalties for executives who do not fulfill their fiduciary responsibilities
five basic principles of finance
- money has a time value
- dollar today is worth more than a dollar received sometime in the future
- we can spend money receives today
- we can earn interest on money receives today
- there is a risk-return tradeoff
- investors are risk-averse
- investors will only take risk if they are compensated with additional return
-
- cash flows are source of value
- profit is just an accounting concept
- firm can show an accounting profit yet have neg. cash flow
- market prices reflect information
- investors respond very quickly to new information by buying and selling
- we treat financial markets as efficient
- individuals respond to incentives
- managers act in their own best interests not the firm’s
- managers may not seek to max stockholder wealth
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