Transcript Introducing Financial Management

Introducing Financial Management
Chapter 1
Fin 325, Section 04 - Spring 2010
Washington State University
1
What is Finance?
 The study of
 Time value of money - savings, loans, mortgage
payments, retirement plan (ch4, ch5)
 Valuation of stocks, bonds (ch6, ch7)
 Financial markets and institutions (ch8)
 Risk and return tradeoff (ch9, ch10)
 Business decisions – cost of capital (ch11),
capital structure (ch14), capital budgeting
(ch12, ch13)
 Financial Management focuses on valuing
things from the perspective of a company.
2
Economic Participants
 We can segment participants along two dimensions:
 Those with/without “extra” money available to invest
 Those with/without economically viable ideas
No extra money
Extra money
No economically
viable business
ideas
Type 1: No
money and no
ideas
Type 2: Money,
but no ideas
Economically
viable business
ideas
Type 3: No
money, but ideas
Type 4: Both
money and ideas
3
Sub-Areas of Finance
1. Investments
2. Financial Management
3. Financial Institutions and Markets
4. International Finance
4
Finance in Your Personal Life
 The financial concepts you learn in this course will
also apply to your personal financial situation
 Borrowing money (student loan, auto loan,
mortgage)
 Refinancing
 Investing
 Retirement planning

Rise of defined contribution plans vs. defined benefit
plans
5
Business Organization
 General business organization forms
 Sole proprietorships
 Partnerships
 Corporations
 Hybrid organizations
 The advantages and disadvantages of forms of
organization can be expressed through the following
dimensions:





Who controls the firm
Who owns the firm
What are the owners’ risks
What access to capital exists
What are the tax ramifications
6
Sole Proprietorships
 The most common type of business organization in the
U.S. (over 70% of businesses). There is no distinction
between the owners’ personal and business assets
 Advantages:
 Easy to start
 Light regulatory and paperwork burden
 Single taxation at the personal tax rate
 Disadvantages
 Unlimited liability
 Limited access to capital
7
Partnerships
 Involves multiple individual owners. Firm
control is determined by the size of the
partners’ ownership stakes. Profits are taxed
at personal income tax rates.
 Advantages:
 Relatively easy to start
 Single taxation
 Disadvantages:
 Partners jointly share unlimited liability
 Difficult to raise large amounts of capital
8
Corporations
 Corporations are legally independent entities
entirely separate from their owners. The world’s
largest businesses are organized as corporations.
 Owners are called shareholders. They elect the
board of directors, who then hire managers of
the firm.
 Advantages:
 Limited liability for owners
 Can raise large amounts of capital
 Easy to transfer ownership
 Disadvantages
 Double taxation (corporate level and personal level)
9
Hybrid Organizations
 To promote the growth of small businesses, the
U.S. government allows for business organizations
that simultaneously offer single taxation and
limited liability
 S Corporations
Do not pay any income taxes at the firm level. Instead, the
corporation's income or losses are divided among and passed
through to its shareholders
 Limited Liability Companies (LLCs) and
Partnerships (LLPs)
10
The Financial Manager
 Chief Financial Officer (CFO)
CFO
 Highest level financial officer
 Controller
Controller
Treasurer
 Oversees the accounting function
(taxes, cost accounting, financial accounting)
 Treasurer
 Responsible for managing cash, credit, financing,
capital budgeting, risk management (hedging)
11
Goals of the Firm
 Owners perspective: Maximize shareholder
wealth (stock price)
 Same as maximizing owners’ equity, or maximizing
the value of the company
 How to measure: maximizing the current value per
share or stock price, of existing shares
12
Agency Theory
 When one party (the principal) hires another
party (the agent) to work for them, this is an
agency relationship and the agent is supposed to
act in the principal’s best interest.
 How does this apply to the firm?
 The stockholders (owners) don’t manage the firm.
They hire managers to operate the firm to maximize
the value of their investment.
 Often, the manager’s best interest does not align
with shareholder goals. This is known as an agency
problem, or principal-agent problem
 Example: CEO buying corporate jet rather than
flying commercial
13
Solving Agency Problem
 Ignore it. If the amount of money is small
enough such perks might add value by
enhancing productivity.
 Monitor the managers.

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Accountants
Debt holders
 Align incentives by making the managers
owners



Equity stakes
Stock options
ESOP (Employee Stock Option Plan)
14
Corporate Governance
 The process of aligning managers’
incentives and monitoring managers
 Inside monitors: the Board of Directors
 Hires the CEO
 Evaluates management
 Designs compensation plans
 Outside monitors





Auditors
Analysts
Banks
Institutional investors
Credit rating agencies
15
Ethics
 Financial professionals manage other
people’s money
 Corporate managers
 Bankers
 Investment advisors
 High standards of ethics
 Stealing from firms = stealing from
shareholders
 Financial scandals: Enron, Worldcom
16
Financial Markets & Intermediaries
 Financial markets and financial intermediaries
play an important role in facilitating the flow of
capital from investors to firms and back to
investors
 Financial institutions acquire specialized expertise
and assets
 These firms often earn very high profits through the
use of these unique characteristics
17