Overview of Managerial Finance Lakehead University September 2003 Overview of Managerial Finance Outline of the Lecture 1.1 Finance as an Area of Study 1.2 Basic Forms of Business Organization 1.4 Goal of the Financial Manager 1.5 The Agency Issue 2
1.1 Finance as an Area of Study What is Finance? Businesses (and individuals) regularly need answers to the following questions: What long term investments to undertake? How to finance these projects? Debt or Equity? How to manage everyday financial activities? A course in corporate finance provides the tools necessary to answer these questions. 3 1.1 Finance as an Area of Study Major Areas in Finance Financial Markets Financial Services Managerial Finance 4
1.1 Finance as an Area of Study Career Opportunities in Managerial Finance Financial Analyst Capital Budgeting Analyst/Manager Project Finance Manager Cash Manager Credit Analyst/Manager Pension Fund Manager 5 1.2 Basic Forms of Business Organization There are three different legal forms of business organization: Sole proprietorship Partnership Corporation 6
Sole Proprietorship Advantages: Simple to form Owner keeps all the profits Disadvantages: Owner has unlimited liability with respect to debt Business income is taxed at the owner s personal income Life of business limited Owner cannot raise more than her own wealth as equity Ownership difficult to transfer 7 Partnership Advantages and disadvantages are basically the same as sole proprietorship, except for partners liability. General partners have unlimited liability, limited partners have limited liability. In a general partnership, all partners have unlimited liability. In a limited partnership, one or more general partners run the business for one or more limited partners. 8
Corporation In terms of size, this is the most important form of organization in Canada. A corporation is a legal entity distinct from its owners. A corporation has rights and responsibilities similar to that of a person: It can borrow money, it can sue and can be sued, etc.. A corporation can be involved in partnerships, and can be the owner of another corporation. 9 Corporation Advantages: Owners have limited liability for the firm s debt Ownership is easy to transfer Life of the firm is basically inifinite Easy to raise cash Disadvantages: Complex to form Agency problems: shareholders-bondholders, shareholders-managers Double taxation of dividends 10
Organization of the Finance Function The size and importance of the managerial finance function depends on the size of the company. In small firms, the financial decisions are usually made by the accounting department. As a firm grows, a separate department is created for the finance function. 11 Board of Directors (elected by shareholders) Chairman of the Board and CEO President and COO V-P Marketing V-P Finance (CFO) V-P Production Treasurer Controller Cash Credit Taxes Accounting Capital Expenditures Financial Planning 12
Financial Decisions Capital Budgeting What type of investment opportunities to consider? Capital Structure How much to borrow? What should the mixture of debt and equity be? Working Capital Management How to manage short-term assets and liabilities? 13 Relationship to Economics Financial managers must be aware of economic principles when making decisions. One of these principles is marginal analysis: Actions should be taken only when added benefits exceed added costs. 14
Example of Marginal Analysis A firm is considering replacing its old computers with new ones. The present value of all benefits from the old computers is evaluated at $35,000. The present value of all benefits from the new computers is evaluated at $100,000. Old computers can be sold for $20,000. New computers cost $75,000. 15 Example of Marginal Analysis (continued) Added benefits from replacing the old computers: $100,000 $35,000 = $65,000. Added costs from replacing the old computers: $75,000 $20,000 = $55,000. Net benefit is then $65,000 $55,000 = $10,000. 16
Emphasis on Cash Flows Under the generally accepted accounting principles (GAAP), sales and expenses are recognized on an accrual basis, which means that revenues and cost of goods sold are recognized at the time of the sale, not when cash is paid. The financial manager is concerned about cash flows, i.e. cash that is actually received and paid by the firm. 17 Cash Flow Example XYZ, Inc., has sold $1M worth of goods in 2000, its first year of operation. $100,000 of the 2000 sales have yet to be paid by customers. In January 2000, XYZ has purchased $5M worth of equipment expected to depreciate to zero in a straight line over 10 years (the equipement loses $500,000 of its value each year). Costs of goods sold were $300,000 during the year, from which $50,000 have yet to be paid by XYZ. 18
Cash Flow Example (continued) Accounting income in 2000: $1,000,000 }{{} Sales in 2000 $300, 000 }{{} COGS in 2000 $500, 000 }{{} Depreciation in 2000 = $200,000. Cash flow in 2000: $900, 000 }{{} Cash from Sales $250, 000 }{{} Cash for COGS $5, 000, 000 }{{} Investments in 2000 = $3,850,000. 19 Key Activities of the Financial Manager Capital Budgeting What type of investment opportunities to consider? Capital Structure How much to borrow? What should the mixture of debt and equity be? Working Capital Management How to manage short-term assets and liabilities? 20
1.4 Goal of the Financial Manager Survive in business? Avoid financial distress? Maximize sales? Maximize profits? Maintain growth in earnings? Maximize the stock price? 21 1.4 Goal of the Financial Manager The right goal needs to take cash flows, the timing of these cash flows and risk into account. Maximizing shareholder wealth takes all these into account. What about other stakeholders (employees, customers, creditors, etc.)? 22
1.4 Goal of the Financial Manager The Role of Ethics Environment-friendly operations Charity donations Timely disclosure of material information Transparent accounting practices 23 1.4 Goal of the Financial Manager Benefits from an Ethics Program Reduce potential litigation and judgement costs Maintain a positive corporate image Build shareholder confidence Gain the loyalty, commitment and respect of the firm s stakeholders 24
1.5 The Agency Issue Agency relationship: A principal (owners) hires an agent (managers) to generate revenues. If the principal cannot perfectly monitor the agent s actions and the latter has goals that differ from those of the owner, then the owner s objectives may not be attained. Managers potential goals: Keep their jobs (take insufficient risks), perquisites, etc. 25 1.5 The Agency Issue Managers goals can be aligned with those of shareholders using the right incentives. Managerial compensation linked to firm s success. Control of the firm in shareholders hands: Takeover threats, independence of directors. 26
1.5 Another Agency Problem Bondholders and shareholders may have conflicting interests. Due to shareholders limited liability, the latter may want to take risks that reduce the market value of debt. On the other hand, shareholders may prefer a dividend to the undertaking of a profitable project, as some of the project s return will be distributed to bondholders, whereas dividends all go to shareholders. 27 Financial Markets and the Corporation Financial markets bring buyers and sellers of capital together. Firms obtain cash from individuals by issuing debt or equity. Individuals obtain cash from firms through dividends, capital gains and interest. 28
Firms issue securities Firms invest in assets Cash reinvested Financial markets Current assets Fixed assets Dividends, interest payments Short-term debt Long-term debt Equity shares Taxes and other Government Other stakeholders 29