CORPORATE FINANCIAL MANAGEMENT. PART I INTRODUCTION (chapter 1-2)

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1 CORPORATE FINANCIAL MANAGEMENT PART I INTRODUCTION (chapter 1-2)

2 Course objectives to enable you to develop the analytical, interpretive, and judgmental abilities required of a financial manager to provide a solid understanding of financial markets and how they operate to provide a wide range of realistic illustrations of financial analysis and management

3 Course objectives to demonstrate the relationship and integration of the finance function of an org with its other essential elements to demonstrate how the financial manager communicates the results of financial analysis to decision makers and shareholders within the org framework

4 schedule Part I Introduction Ch.1 The Role and Objective of Financial Management Ch.2 The Domestic and International Financial Marketplace Part II Determinants of Valuation Ch. 4 The Time Value of Money Ch. 5 Analysis of Risk and Return Ch. 6-7 Valuation of Financial Assets

5 schedule Part III The Capital Investment Decision Ch.8 Capital Budgeting and Cash Flow Analysis Ch.9 Decision Criteria and Option Considerations Ch.10 Capital Budgeting and Risk Ch.11 The cost of Capital Part IV The Capital Structure and Dividend Policy Ch. 12 Capital Structure Concept Ch. 13 Capital Structure Management in Practice Ch. 14 Dividend Policy

6 schedule Part V Working Capital Management Ch.15 Financial Forecasting and Working Capital Policy Ch.16 The Management of Cash and Marketable Securities Ch.17 Management of Accounts Receivable and Inventories Part VI Advanced Topics Ch. 19 Lease Financing Ch. 20 Financing With Derivatives

7 Assessment Homework 10% Quizzes 10% Project 20% Final exam 60% Total 100%

8 Chapter 1 The Role and Objective of the Financial Management

9 Introduction 1. Definition of Financial management 2. Forms of business organization 3. Objective of financial management 4. Organization of the financial management function 5. Financial management and other disciplines

10 1. Definition of Finance Financial management is concerned with the maintenance and creation of economic value or wealth/responsibilities and activities of financial managers Responsibilities of financial managers: acquiring funds needed by a firm and for directing those funds into projects that will maximize the value of the firm for its owners

11 2. Forms of business organizations 1) Sole proprietorship 2) Partnership 3) Corporation 4) Factors related to optimal forms of organization 5) Agency problems in corporation

12 1) Sole Proprietorship Owned by one person Easy formation advantage Unlimited liability disadvantage Difficulty raising funds disadvantage Represent 75 percent of all businesses Account for less than 6% of the dollar volume

13 2) Partnership Owned by two or more persons Classified as general or limited General Partner Has unlimited liability for all obligations of the business disadvantage Limited Partner Liability limited to the partnership agreement advantage Partnership dissolves when a general partner dies or withdraws, a new partner entries. disadvantage

14 3) Corporation Legal entity composed of one or more actual individuals or legal entities Limited liability Flexibility, Easy marketability of shares of ownership Permanency All advantages Ability to raise capital

15 4) Optimal form of organization influenced by Cost Complexity Liability Continuity Raising capital Decision making Tax considerations

16 5) Agency problems in corporation Stockholders elect a board of directors Board of directors then elect the officers Chairman of the board Chief executive officer (CEO) Chief operating officer (COO) President Chief financial officer (CFO) Vice presidents Treasurer Secretary Management

17 ...continued Board of directors deals with broad policy 3 to 5 year strategic plan Management makes most of the decisions Day-to-day decisions following the strategic plan

18 ...continued Agency relationship The principals hire the agents to perform a service on behalf of the principles. Agency problems Inefficiencies that arise because of agency relationship Agency costs The costs incurred to minimize agency problems

19 a. Owners and management Problems created by separation of owners and management Management may maximize its own welfare [higher compensation,more leisure time and lower risk] instead of the owners wealth. e.g. job security, the consumption of on-the-job perquisites./ moral hazard, adverse selection Agency costs [Min.] costs to motivate costs to monitor bonding expenditure the opportunity cost of loss profits

20 b. Owners and creditors Problems created by different returns offered to owners and creditors investment of higher risk approved by stockholders new debt issuing approved by stockholders Agency costs protective covenants in bond indentures e.g. limitation on dividend, debt issuing, in(di)vestment and certain ratios, poison put, etc. a higher fixed return e.g. RJR Nabisco was required by KKR

21 3. Objective of financial management 1) Profit maximization 2) Shareholder wealth maximization the primary goal 3) Social responsibility concerns

22 1) Profit maximization MC=MB Lacks a time dimension offers no explicit basis for comparing long-term and short-term profits. Definition of profit (GAAP) Total amount / ROE / EPS p13 Not considers the risk

23 2) Shareholder Wealth Maximization shareholder wealth = market price of common stock (firm value) = present value of the expected future returns to owners

24 a. SWM objective benefits Considers the timing and risk of the benefits from stock ownership Determines that a good decision increases the price of the firm s common stock (C/S) Is an impersonal objective

25 b. SWM is a market concept Maximizing Net Present Value of Cash Flows Measured by Market Value of Common Stock

26 (1) Cash flow king vital central important to the prosperity and survival of a firm

27 Figure 1.1 A Firm s Cash Flow Generation Process......continued 27

28 ...continued Cash Flows Accounting profit (earnings) CF is an unambiguous, clear measure used for evaluating performance and making decisions. CF avoids short-term manipulation by managers and conduces to take a long-term perspective in decision making.

29 (2) NPV of an Investment = PV of future cash flows - cash outlays The NPV of an investment represents the contributions of that investment to the value of the firm and passes on to SWM. a framework for evaluating future cash flows from an investment or a firm a bridge between CF and SWM

30 (3) Market value of common stock Three Basic Factors Determine ~ Amount of Timing of Expected cash flows Risk of

31 ...continued External Conditions Affecting ~ Economic environment factors Political environment factors Conditions in financial markets

32 ...continued Competitive Forces Influencing ~ New entrants Substitute products Bargaining power of buyers Bargaining power of suppliers Rivalry among current competitors

33 ...continued

34 3) Social responsibility concerns Run business in the interests of stakeholders customers suppliers employees creditors community government stockholders, etc. Be a good citizen; contribute to SWM

35 Small business Characteristics grow rapidly raise capital difficultly lack the depth of managerial talent More rely on accounting-based measures Agency problems only exist in relation between owners and creditors

36 4. Organization of the FM function CFO / Vice-president of finance Controller & Treasurer

37 Figure 1.2 Organization of the FM function Board of Director Chief Executive Officer (CEO) Finance Committee VP-Human Resources VP- Marketing VP- Finance (CFO) VP- Engineering VP- Manufacturing Controller Treasurer Financial Accounting Cost Accounting Internal Auditing Tax Accounting Accounts Payable Information Systems Cash /M&S Management Capital Budgeting Analysis Financial Planning Credit Analysis Investor Relations Risk and Insurance Management Pension Fund Management

38 5. Disciplines impacting finance Economics Accounting Marketing Production Human Resources Quantitative Analysis MIS Finance

39 Chapter 2 The Domestic and International Financial Marketplace

40 Introduction 1. An overview of the U.S. financial system 2. The structure and operations of U.S. security markets 3. Market efficiency 4. Income taxes and financial management 5. Ten axioms that form the bases of financial management

41 1. the U.S. financial system The vehicle that channels funds from saving units to investing units

42 Figure 2.1 Flow-of-Funds Diagram......continued 42

43 Financial market...continued The vehicles through which financial assets are traded. Money Market dealing in short-term securities having maturities of one year or less. Capital Market dealing in long-term securities having maturities greater than one year.

44 ...continued Primary Market Market where new securities are sold Money goes to the issuer Sold through a prospectus Secondary Market Market for existing securities are traded among investors

45 2. the U.S. security markets Secondary Market Listed exchanges (e.g. NYSE) Designated place of business Requirements of securities listed or traded Over-the-counter (OTC) market Networks connected by communications Dealers post prices to buy and sell Stock market indexes DJIA, DJTA, S&P 500, NASDAQ

46 ...continued Regulations Federal Securities Act of 1933 Securities Exchange Act of 1934 Securities & Exchange Commission (SEC) Regulates disclosure of information in new securities and all publicly traded firms Example: Insider trading SEC attempts to prevent profiting from unpublished information.

47 3. Capital market efficiency Capital markets are efficient if stock prices provide an unbiased estimate of the true value of an enterprise. if prices instantaneously and fully reflect all the risk and economically relevant information about a security s prospective returns. Glue that bonds the PV of a firm s net cash flow to shareholders wealth

48 1) Three degrees of market efficiency a. Weak form b. Semi-strong form c. Strong form

49 a. Weak form Security prices fully reflect all historical information. No investor can earn excess returns using historical prices or returns. technical analysis

50 b. Semi-strong form Security prices fully reflect historical and publicly available information. No investor can earn excess returns based on an investment strategy using public information. fundamental analysis

51 c. Strong form Security prices fully reflect all historical, public, and private information. No investor can earn excess returns using public and private information.

52 2) Market efficiency implications for financial managers Timing or gambling An expected NPV of zero (i.e. expected return equals required return) Corporate diversification - unnecessary Security price adjustment reflect expected cash flows and risk of the cash flows Behavioral finance perspective anomalies show investors may not be fully rational

53 Holding period return ( HPR) The return from holding an investment for one period holding period yield, realized or ex post rate of return Ending price Beginning price + Distributions 100% Beginning price

54 4. Income taxes Appendix A Implications for financial managers Capital structure policy Debt or equity financing Dividend policy Paying dividends or retaining earnings Capital budgeting After-tax cash flows Lease or buy decision Leveraged leases p730

55 Taxable income = Revenues - Tax deductions Operating or ordinary income Capital gains income Dividend income Loss carrybacks and carryforwards Income tax rates marginal tax rate average tax rate S corporation...continued

56 Depreciation methods...continued MACRS For tax purpose Asset class [ Recovery period ] 3, 5, 7, 10, 15, 20 / 27.5, 31.5(or 39) years Depreciation methods 200%DB, 150%DB / Straight-line method Half-year convention / Mid-month convention Expected salvage value is ignored. Depreciation allowances affect income tax owed, then cash flows available to shareholders

57 5.Ten axioms 1 The risk-return trade-off we won t take on additional risk unless we expect to be compensated with additional return.

58 The risk-return return relationship expected return expected return for taking on added risk expected return for delaying consumption risk

59 Ten axioms 2 All risk is not equal Some risk can be diversified away, and some cannot re tu rn Asset A Combination of asset A and B Asset B time

60 Ten axioms 3 The time value of money A dollar received today is worth more than a dollar received in the future

61 Ten axioms 4Cash- not profits- is king

62 Ten axioms 5 Incremental cash flows It s only what changes that counts

63 Ten axioms 6Taxes bias business decisions

64 Ten axioms 7 The curse of competitive markets Why it s hard to find exceptionality profitable projects

65 Ten axioms 8 Efficient capital markets The markets are quick and the prices are right. In the efficient market, the speed with which securities prices reflect all available information is so quick that there are no opportunities for investors to earn excess profit from the available information.

66 Ten axioms 9 The agency problem Managers won t work for the owners unless it s in their best interest

67 Ten axioms 0 Ethical consideration Ethical behavior is doing the right thing, and ethical dilemmas are everywhere in finance.

68 Ten axioms 3:

Contemporary Financial Management 8th Edition

Contemporary Financial Management 8th Edition by Moyer,, McGuigan, and Kretlow Prepared by Tom Peacock University of Houston 2001 South-Western College Publishing Chapter 1 The Role and Objective of Financial