Transcript Chapter One - nubacad.com

Chapter One
Principles of Finance
By
Farhana Rob Shampa
1
Definition: What is Finance?
“Finance is the methodology of allocating
financial resources with a financial value,
is an optimal manner to maximize the
wealth of a business enterprise.”
“ Finance is the process of channeling
funds from savers to users in the form of
credit, loans or invested capital through
agencies including commercial banks
savings and loan associations.”
2
Career Opportunities
in Finance:
 Financial
markets
 Investments
 Managerial finance

Financial institutions
•
•
•
•
Banks
Insurance companies
Savings and loans
Credit unions
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The Financial Manager’s
Responsibilities:
 Obtain
and use funds in a way that will
maximize the value of the firm:
1. Forecasting and planning.
2. Major investment and financing decisions
3. Coordination and control
4. Dealing with financial markets
4
Finance Function:
 1)
Investment Decision.
 2) Financing Decision.
 3) Dividend Decision.
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Basic Forms of Business
Organization:
 Sole

Proprietorship
Owned by one person, operated for personal
profit.
 Partnerships

Owned by two or more people, operated for
joint profit.
 Corporations

“Legal entity”, owned by individuals, operated
for joint profit.
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Sole Proprietorship:
STRENGTHS:
 Low organizational
cost
 Income taxed once as
personal income
 Independence
 Secrecy
 Ease of dissolution
WEAKNESSES:
 Unlimited liability
 Limited funding
 Proprietor must be all
 Difficult to develop
staff career
opportunities
 Lack of continuity on
death of proprietor
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Partnerships
STRENGTHS:
 Improved funding
sources
 Increased managerial
talent
 Income split by
partnership contract,
taxed as personal
income
WEAKNESSES:
 Unlimited liability to all
partners
 Partnership dissolved
upon death of partner
 Difficult to liquidate or
transfer ownership
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Principles of Finance:
 A)
Principles of Risk and Return.
 B) Principles of Time value of Money
 C) Principles of Cash Flow.
 D) Principles of Profitability and Liquidity.
 E) Principles of Diversity.
 F) Hedging Principles.
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Corporations
STRENGTHS:
 Owners’ liability limited
 Large capitalization
possible, greater funding
 Ownership readily
transferable
 Indefinite life
 Professional
management
WEAKNESSES:
 Higher tax rates
 Expensive organization
 Greater government
regulation
 When publicly traded,
lacks secrecy
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Goal of the Firm /Corporation:
 There
are two approaches in the
corporation goal are:
•A) Profit Maximization
•B) Wealth Maximization
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Goal of a Manager
•Profit Maximization
Or
Wealth Maximization
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Profit Maximization:

Corporations commonly define profit as
“Earnings per Share” (EPS). EPS
represent the amount of profit earned
during the period on behalf of each
outstanding share of common stock. (A
measure of total earnings divided by total
number of ownership shares. )
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Profit maximization

Profit maximization means maximizing the
income of the firm. Profit maximization
ensures that firms utilize its resources
efficiently. Profit maximization leads to
efficiently. Profit maximization leads to
efficient allocation of resources. It is a short
term view.
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Profit Maximization:
 EPS
ignores critical factors of / Limitations
of profit maximization are :



It ignores the timing of the returns.
It ignores cash flows available to common
shareholders.
It ignores risk factors facing the firm.
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Shareholder Wealth Maximization:
The Goals of the Corporation
Management’ primary goal is stockholder wealth
maximization. Shareholder wealth maximization
is the value of the firm as measured by the price
of the firm’s common stock.
 Stock price maximization is the most important
goal of most corporations. Shareholder wealth
maximization is a more comprehensive goal for
the firm, its managers and employees. It is a
long term view.

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Shareholder Wealth Maximization
(SWM)

Shareholder Wealth Maximization (SWM) means
maximizing owners economic welfare.
 Maximizing owners economic welfare is
equivalent to Maximizing the utility of their
consumption over time.
 A firm should be maximize the market value of
its shares. Market price of a share is reflection of
the firm’s financial performance.
 Maximized value of the firm as measured by the
price of the firm’s common stock.
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SWM
 Because
it (SWM) evaluating Shareholder
wealth addresses factors of timing
associated with expected earnings per
share , cash flows and risk ignored by the
EPS.
 This can be explored through “economic
valued added” and a focus on
stakeholders.
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Shareholder Wealth Maximization:
Financial goal
 Wealth
maximization is the net present
value (or wealth) of a firm.
 A financial action which has a positive
value creates wealth.
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Economic Value Added – EVA:
 EVA measures
whether an investment
contributes to shareholder wealth.
 EVA is calculated by subtracting cost of
funds used from after-tax operating profits.
 While popular, EVA is essentially derived
from the concept of “net present value.”
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Stakeholders
 Stakeholders
include groups that have
direct economic links to the firm.
 Stakeholders include not only owners, but
also employees, customers, suppliers, and
creditors.
 Maintaining positive stakeholder
relationships helps maximize long-term
benefits to shareholders.
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Shareholder Wealth Maximization:

Shareholder Wealth Maximization (SWM) means
maximizing owners economic welfare.
 Maximizing owners economic welfare is
equivalent to Maximizing the utility of their
consumption over time.
 A firm should be maximize the market value of
its shares. Market price of a share is reflection of
the firm’s financial performance.
 Maximized value of the firm as measured by the
price of the firm’s common stock.
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Rationale Behind Wealth
Maximization as the Goal of a Firm:
 A)
Clear concept.
 B) It considers risk, timing of return and
time value of money.
 C) Focus on market price of share.
 D) Economic Vale Addition.
 E) Stake holders
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From the social perspective wealth
maximization:
 1)
Is to maximize shareholders wealth
maximize stock price.
 2) Employee welfare, achieve personal
goal.
 3) Ecological/ environment harmony.
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What about Stakeholders?
 Stakeholders
include groups that have
direct economic links to the firm.
 Stakeholders include not only owners, but
also employees, customers, suppliers, and
creditors.
 Maintaining positive stakeholder
relationships helps maximize long-term
benefits to shareholders.
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Agency Issues:

An agency relationship exists when one or more
people (the principals) hire another person (the
agent) to perform a service and then delegate
decision-making authority to that agent . The
important agency relationship exist :
 1) The principles (share holders ) and the
managers.
 2) Stockholders and creditors (debt holders).
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Agency Issues:
The Principal-Agent Problem

Whenever ownership is independent of
management there exists potential problem of
conflicts.
 The owner’s goals for the firm are best
described as maximizing shareholder wealth.
 Managers are also concerned with personal
wealth, job security, lifestyle, and benefits.
These concerns may conflict with shareholder
interests.
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Agency Problem:
 A potential
conflict of interest between:
 1)
The principles (share holders ) and the
managers.
 2)
Stockholders and creditors (debt
holders).
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Agency Problem:
 Agency
problem the like hood that
managers may place personal goals
ahead of corporate goals.
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Ways to motive managers to act in
the best interest of shareholders:
 1)
The Threat of firing.
 2)
The Threat of Takeover.
 3)
Structuring Managerial Incentives.
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1) The Threat of firing.
 Existing
share holders attempt of ousted
the present management team by
stockholders to voting rights and elected
new management team.
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The Threat of firing resistance by
present management team:

Current Management attempt of gain control of
a firm by soliciting stockholders to vote for a
new management team.
 It wasn’t long ago that the management teams of
large firms felt secure in their positions, because
the chances of ousted by being stockholders
were so remote that managements rarely felt
their jobs are in jeopardy. This situation existed
because ownership of most of the
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Proxy fight:
 firms
ownership was so widely distributed,
and management’s can control over the
voting system by proxy (voting)
mechanism was so strong, that it was
almost impossible for dissident
stockholders to gain enough votes to
overthrow the managers.
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2) The Threat of Takeover.
 A)
Hostile takeovers: The acquisition of a
company over the opposition of its
management.
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The Threat of Takeover.
resistance by present management team:
 i)
Poison Pill.
 ii) Green mail.
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i) Poison Pill.
 An
action a firm can take that practically
kills it and thus to make a firm unattractive
to potential buyers and thus to avoid a
hostile takeovers.
 “If you want to keep control, don’t let your
company’s stock sell at a bargain price.”
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Poison Pill.
(Con)
 Actions
to increase the firm’s stock price
and to keep it form being a bargain
obviously are good from the standpoint of
the stockholders, but other tactics that
managers can use to ward off a hostile
takeover might not be.
 (Golden Parachutes, Golden Handshake)
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ii) Green mail.
 Which
is like blackmail.
 A situation in which a firm, trying to avoid a
takeover, buys back stock at a price above
the existing market price from the person
(s) trying to gain control of the firm.
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ii) Green mail.
 i) A potential
acquirer (firm or individual)
buys a block of stock in a company.
 ii) The target company’s management
becomes frightened that the acquirer will
make a tender offer and gain control of the
company.
 iii) To head off a possible takeover,
management offers to pay greenmail,
buying the stock owned by the potential
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ii) Green mail (Con)
 Raider
at a price above the existing
market price without offering the same
deal to other stockholders.
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3) Structuring Managerial
Incentives
 Executive
compensation packages
generally include incentive plans that grant
stock options, performance based shares,
or cash bonuses upon meeting or
exceeding corporate goals.
 Such packages may also include longterm benefits that can protect the manager
against poor corporate performance.
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Current View on Incentive Plans:
 A type
of incentives plan that allows
managers to purchase stock at some
future time at a given price.
 1) Executive Stock Option.
 2) Performance Share.
 3) Cash Bonus
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2) Shareholders versus Creditors:
 It
stockholders approve actions that harm
the position of the firm’s creditors, it is
likely that the firm’s creditors, it is likely
that the firm will find it difficult to borrow
funds in the future.
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Resolving the Agency Problem

Directors is the heart of any resolution.
 1) Market Forces.
 2) Agency Costs – the costs of this governance:


Monitoring costs,
Structuring compensation costs.

1) Market Forces : Market forces, such as the
potential for hostile takeover provide some
deterrence.
 Legal forces, fraud, and fiduciary misconduct
laws aim to act as deterrents as well.
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Resolving the Agency Problem:

A) Monitoring costs,
B) Structuring compensation costs :
1) Executive Stock Option.
 2) Performance Share.
 3) Cash Bonus
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Factors Influencing Financial
Decisions:
 A)
Internal Factors.
 External Factors.
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Internal Factors:
 1)
Size of the Business.
 2) Nature of Business.
 3) Situation of Business Cycle.
 4) Assets Structure
 5) Terms of Credit.
 6) Management Philosophy.
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External Factors:
 1)
Govt Regulations.
 2) Tax System.
 3) Economic Condition of the Country.
 4) Condition of Money Market & Capital
Market.
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Questions:
 1)
Define what is Finance?
 2) What role should financial managers
play in the modern enterprise?
 3) Write down the function of Finance?
 4) In what way is the wealth maximization
objectives superior to the profit
maximization? Explain
 5) What is management’ primary goal?
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