Lecture 2 (a) The Firm & the Financial Manager Finance is about money and markets, but it is also about people. The success of a corporation depends on how well it harnesses everyone to work to a common end. This section, therefore, will introduce the most basic forms of a business and the responsibilities of its financial managers. 1
The Role of the Financial Manager In General Regardless of the way a business is organized, financial manager forms the crucial link between the internal environment and the outside world of the organization. (2) (1) Firm s Operations Financial Manager (4a) Financial Markets (3) (4b) (1) Cash raised from investors (2) Cash invested in firm (3) Cash generated from operations (4a) Cash reinvested (4b) Cash returned to investors 2
The Role of the Financial Manager Decision-Making It is the responsibility of the financial manager to strike a fine balance between the two kinds of decision-making Firm s Operations Financial Manager Financial Markets Capital Budgeting Decision Decisions as to which real assets the firm should acquire Financing Decision Decisions as to how to raise the money to pay for investments in real assets 3
The Role of the Financial Manager Which Assets to Acquire? Generically speaking, there are two broad categories of assets which can be acquired by the organization: Real Assets These are the assets which are used to produce goods or render services; To carry on business, firms need an almost endless variety of such assets; Examples of real assets include machinery, factory, building, office and raw material etc. Financial Assets These are the assets which give the bearer claims on the firm s real assets and the cash those assets will produce; In simplest of terms, these are the assets which the firm sells to obtain funds; For example, if a company borrows from a bank, the bank has a financial asset. This financial asset gives the bank entitlement of the stream of interest payments and the principal repayment. 4
The Role of the Financial Manager From Where to Raise the Money? Remember the same-old accounting equation where: Assets = Liabilities + Owner s Equity Plugging in the things which we have learned until now, we can rewrite the above equation as: Real Assets + Financial Assets = Liabilities + Owner s Equity We can also replace the technical jargon on the right-hand side so that: Real Assets + Financial Assets = Borrowed Money + Our Own Money The above equation describes the simple logic behind many financial theories i.e. you can acquire assets either by using your money or borrowing from someone else. 5
The Role of the Financial Manager From Where to Raise the Money? In addition to deciding between the assets the financial manager should acquire, he/she also has to choose the long term financing mix for the company which is commonly known as the capital structure. In its very basic form, the financial manager has two choices: It can invite investors to put up cash in return for a share of profits (This is synonymous to issuing shares and raising equity by making the shareholders coowners of the firm); It can promise investors a series of fixed payments in return of the funding (This is synonymous to borrowing money from a lender who must one day be repaid). 6
Lecture 2 (a) Appendix A few important topics not directly related with the lecture discussed are included in this section. 7
Goals of the Corporation Reason For Existence Instead of jumping down to the conclusion, lets deliberate as to what should be the goal of the firm: Should the management only strive to maximize profits (obviously by staying within the legal framework)? Should the management only strive to maximize the sales of the firm? Or should the management try to minimize the operational and financial risk associated with the firm? So which one do you think is the right target to have or do you have something else in mind and think that all of the above have deficiencies? 8
Goals of the Corporation Reason For Existence For small organizations, management and the owner of the firm may be the same but for large companies like PSO and Unilever, it would be a practical necessity to separate ownership from management as there is no way hundreds of investors can be actively involved in management. With different tastes, wealth, time horizons and personal opportunities, it becomes a problem for shareholders to delegate authority. Fortunately, there is a natural financial objective on which almost all investors agree i.e. to maximize the current value of their investment. Thus, ideally speaking the goal should be to make and execute decisions that have the salient impact of maximizing the price of the firm s common stock, which is equivalent to maximizing shareholders wealth. 9
The Agency Theory General Introduction With the power vested in them by the shareholders (owners) of the company, financial managers are theoretically expected to act in the best interest of the shareholder. However, things are always not straight and there are times when there exists a potential conflict of interest between the management and the stakeholders. When this happens, an agency problem between the manager (agent) and The outside stockholder (principal); The lenders (principal) arises. 10
The Agency Theory Stockholders Versus Managers In case of large corporations where financial managers own a little or no percentage in the ownership, shareholder wealth maximization tend to take a back seat to a number of conflicting managerial goals. It has long been argued that they always: Want to create rapidly growing large organizations; Have large appetite for salaries and perquisites; Take away the credit of making donations at the expense of shareholders. However, there are ways with which managers can be motivated to act in the best interest of the shareholders: Managerial compensation; Direct intervention by shareholders; Threat of firing and takeover. 11
The Agency Theory Stockholders (Through Managers) Versus Lenders (Creditors) Similar to the shareholder-manager conflict, there exist situations where shareholders try to gain at the expense of creditors thereby creating another branch of agency problem. Creditors lend funds at rates that are based on: The riskiness of the firm s existing assets; Expectations concerning the riskiness of future asset additions; The firm s existing capital structure; Expectations concerning future capital structure decisions. So keeping this in mind, should stockholders expropriate creditors by: Taking up a project which is far riskier than what creditors anticipated; Borrowing funds and then using them to buy their stocks back thereby leveraging up the firm and consequently jacking their return on equity up. 12