AN OVERVIEW OF FINANCIAL MANAGEMENT
After you finish the chapter, you should have a reasonably good idea of what finance majors might do after graduation. You should also have a better understanding of :
1) Some of the forces that will affect financial management in the future : the way businesses are organized.
2) The place finance has in a firm’s organization.
3) The relationships b/w financial managers and their counterparts (accounting, marketing, production etc.).
4) The goals of a firm.
5) The way financial managers can contribute to the attainment of these goals.
CAREER OPPORTUNITIES IN FINANCE :
1) Money and Capital Markets : banks, finance institutions, insurance companies, etc.
2) Investments : brokerage houses, individual or institutions’ portfolio.
3) Financial Management (Business Finance) : actual management of a firm.
If you decide to make finance your career, you will need to know something about all three areas.
* Suppose you do not plan to major in finance, is it still important ? Yes or No!
Absolutely yes! Because :
1) You need a knowledge of finance to make many personal decisions
2) All important business decisions have financial implications
FINANCIAL MANAGEMENT IN THE NEW MILLENNIUM
legal aspects of mergers, formation of new firms, securities to raise capital
bankruptcy & reorganization, liquidity
descriptive, outsider’s view than manager
Late 1950s : theoretical analysis began ; focus shifted to managerial decisions regarding the choice of assets & liabilities so as to maximize the value of the firm
The focus on value maximization has continued as we begin 21st century but two other trends have become increasingly important in recent years:
1) the globalization of business
2) the increased use of information technology
Globalization of Business (see Table 1–1 P. 7)
4 factors global business
(1) Improvement in transportation & communications
lowered shipping costs international
trade more feasible.
(2) Increasing political clout of consumers, (desire low– cost, high–quality products) helped lower trade barriers.
(3) Technology become more advanced the cost of developing new products has increased led to joint ventures. i.e. GM & Toyota
(4) Multinational firms able to shift production to wherever costs are lower.
distant colleagues, e–commerce
Next generation of financial managers will need stronger computer and quantitative skills.
INCREASING IMPORTANCE OF FINANCIAL MANGEMENT
marketing : project sales
Earlier times production : determine the assets
finance : raised the money needed
Recently : no longer exists * decisions are now made in much more coordinated manner.
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> $ 60
gone bankrupt :
> $ 80 :
* There are financial implications in virtually all business decisions, and nonfinancial executives simply must know enough finance to work these implications into their own specialized analysis .*
CEOs of the top 1,000 U.S. companies started their careers in finance.
THE FINANCIAL STAFF’S RESPONSIBILITIES
The financial manager’s task is to acquire and use funds so as to maximize the value of the firm.
1) Forecasting and planning.
2) Major investment and financing decisions.
3) Coordination and control.
4) Dealing with the financial markets. CH. 5
5) Risk management. CH. 18
ALTERNATIVE FORMS OF BUSINESS ORGANIZATION
1) Sole Proprietorship
Hybrid Forms of Organization (P. 14)
FINANCE IN THE ORGANIZATIONAL STRUCTURE OF THE FIRM
P. 15 Fig. 1–1
THE GOALS OF THE CORPORATION
Primary and most important goal :
“Stockholder wealth maximization”
“Maximizing the price of the firm’s common stock”
Should managers consider “stockholder wealth maximization” as a goal? If not, what would happen ?
Managerial Incentives to Maximization Shareholder Wealth
Management is supposed to operate in the best interests of the stockholders.
It is almost impossible to determine whether a particular management team is trying to maximize shareholder wealth or is merely attempting to keep stockholders satisfied while pursuing other goals.
It is impossible to give definite answers – but a competitive market will force the managers to undertake actions that are reasonably consistent with shareholder wealth maximization.
Should businesses operate strictly in their stockholders’ best interest, or are firms also responsible for the welfare of their employees, customers, and the communities in which they operate ?
Social responsibility incur voluntarily cost.
Disadvantages cannot compete ROI
so mandatory rather than voluntarily.
However, now more and more firms voluntarily : Why ?
Stock Price Maximization and Social Welfare
If a firm attempts to maximize its stock price, is this good or bad for society ? General, it is good ! The same actions that maximize stock prices also benefit society : because stock price maximization :
1) requires efficient, low–cost businesses that produce high–quality goods and services at the lowest possible cost.
2) requires the development of products and services that consumers want and need ; so the profit motive leads to new technology, to new products, and to new jobs.
“standards of conduct or moral behavior”
Company's attitude and conduct toward its employees,
customers, community, and stockholders
High standards of ethical behavior : a firm treat each party that
it deals with in a fair and honest manner.
Product safety & quality, fair employment practices, fair
marketing & selling practices, community involvement.
Conflicts often arise b/w profits and ethics.
How would you respond?
Ex. Coal trains are polluting the air along its routes, but the amount of pollution is within legal limits and preventive actions would be costly.
Or medical products……..
* There are no obvious answers to these questions, but companies must deal with them on a regular basis, and a failure to handle the situation properly can lead to huge product liability suits and even to bankruptcy.
One or more people (the principals) hire another person (the agent) to perform a service and then delegate decision-making authority to the agent.
Agency Conflict (Problem)
1) b/w managers and stockholders
2) b/w stockholders and debtholders (creditors)
Stockholders versus Managers
Managers can be encouraged to act in the stockholders’ best interests through a set of incentives, constraints, and punishments .
These tools are effective if “observe all the time” but unobserved actions : “moral hazard” problem
agency costs arise
Some specific mechanism which encourage managers to act in shareholders’ interest :
1) Managerial compensation based incentive plans.
2) Direct intervention by shareholders.
3) The threat of firing.
4) The threat of takeovers.
1) Managerial compensation:
The structure of the compensation package can and should be designed to meet two primary objectives:
(1) to attract and retain able managers
(2) to align managers' actions as closely as possible with the interests of stockholders
Typical senior executives compensation is structured in three parts:
(1) a specified annual salary meet living expenses
(2) a bonus paid at the end of the year depends on the company's profitability
(3) options to buy stock
Performance shares: Number of shares dependent upon the company's actual performance and executive's continued service.
i.e. 1991 Coca - Cola ----- $ 81 million to CEO (Roberto Goizueta)
Executive stock options: Allow managers to purchase stock at some future time at a given price.
i.e. 10,000 shares at B 30 in 5 years.
Criteria : past EPS, ROE
recently MVA, EVA
2) Direct intervention by shareholders :
Although a great deal of stock is owned by individuals, an increasing percentage is owned by institutional investors (pension funds, mutual funds, insurance companies etc.).
Therefore, the institutional money managers have the clout, if they choose to use it, to exercise considerable influence over most firms' operations.
3) The threat of firing :
Until recently, the probability of a large firm’s management being ousted by its stockholders was so remote. However, that situation is changing. Ex. p. 23 - 24 Compaq, Kodak (resigned).
4) The threat of takeovers :
Hostile takeovers : (when management does not want the firm to be taken over) are likely to occur when a firm’s stock is undervalued relative to potential because of poor management.
If hostile takeovers happened ; managers of the acquired firm are generally fired. Thus, managers have a strong incentive to take actions which maximize stock prices.
Stockholders (through Managers) versus Creditors
Creditors : receive “i” and “principal”.
Creditors lend funds to a firm at rates that are based on:
1) The riskiness of firm’s existing assets.
2) Expectations concerning the riskiness of future asset additions.
3) The firm’s existing capital structure.
4) Expectations concerning future capital structure changes.
i.e. - Invest higher risk project : “Heads I win, tail you lose”.
- Borrow additional fund (debt) to repurchase some of the firm's outstanding stock "leverage up" ROE .
* stockholders tend to gain at the expense of creditors*
MANAGERIAL ACTIONS TO MAXIMIZE SHAREHOLDER WEALTH
To maximize the price of a firm’s stock, what types of actions should its management take ? Need to ask:
What factors determine the price of a company's stock?
Three basic facts :
(1) Any financial assets, including company's stock, is valuable only to the extent that the asset generates cash flows.
(2) The timing of cash flows matter.
(3) Investors are generally avers to risk, so all else equal, they will pay more for a stock whose cash flows are relatively certain.
Stock price is affected by
Fig. 1-2 P.26
DOES IT MAKE SENSE TO TRY TO MAXIMIZE EARNINGS PER SHARE?
How about profit maximization or maximization of earnings per share (EPS).
Even growing number of analysts rely on cash flow projections to assess performance, at least as much attention is still paid to accounting measures:
(1) They are easy to use and understand.
(2) They are calculated on the basis of more or less standardized accounting practices.
(3) Net Income is supposed to be reflective of the firms's potential to produce cash flows over time.
Generally, there is a high correlation b/w EPS, cash flow, and stock price; however:
(1) There are also important distinctions b/w earnings and cash flows.
(2) A firm's stock price is affected by both its performance this year and its expected performance in the future.
*Even though cash flows ultimately determine stockholder value, financial managers cannot ignore the effects of their decisions on reported EPS.
Keep in Mind
The primary goal of management is to help maximize the value of the firm. To achieve this goal, managers must have a general understanding of how business are organized, how financial markets operate, how interest rates are determined, how tax system operates, and how accounting data are used to evaluate a business’s performance. In addition, managers must have a good understanding of some fundamental concepts, including discounted cash flow analysis, risk analysis, asset valuation, and evaluation of investment opportunities.
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