1 Contemporary Corporate Finance, 11th Edition ©2009 South-Western/Cengage By McGuigan, Kretlow,...

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Contemporary Corporate Contemporary Corporate Finance, 11th EditionFinance, 11th Edition

©2009 South-Western/Cengage

By

McGuigan, Kretlow, and Moyer

Prepared by

Rand MartinBloomsburg University of Pennsylvania

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The Role and Objective of

Financial Management

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Introduction

This chapter introduces the financial management process of the typical firm. It looks at the field of finance, various financial decisions and their implications, and the daily questions faced by the firm’s financial managers.

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Questions Faced by Financial Managers Will a particular investment be

successful? Where will the funds come from to finance

the investment? Does the firm have adequate cash or

access to cash to meet its daily operating needs?

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Principal Forms of Business Organizations

Sole proprietorship

Partnership

Corporation

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Sole Proprietorship

Owned by one person Advantage: Easy formation Disadvantage: Unlimited liability Disadvantage: Difficulty raising funds Represent 75 percent of all businesses Account for less than 6 percent of total

business revenues

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Partnership

Owned by two or more persons About 7 percent of US businesses, 5 percent of

business revenues Classified as general or limited General partners work in the partnership Advantage: Limited partners’ liability is limited

to what is specified in the agreement. Disadvantage: Partnership dissolves when a

general partner dies Disadvantage: Unlimited liability for general

partners

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Corporation

Limited liability

Permanency

Ability to raise capital

Has a board of directors

Owners are stockholders

Flexibility

Legal entity

Easy marketability of shares of ownership

All advantages

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Board of Directors

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

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Who Does What?

Board of directors deals with broad policy

The board sets 3 to 5 year strategic plans

Management makes most of the decisions

Management makes day-to-day decisions following the strategic plan

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Stockholder Rights

Dividends

Asset

Voting for board members, major policy

Preemptive rights on new shares

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Priority of Corporate SecuritiesDebt Securities (Bonds) (highest)

Preferred stock (P/S)

Common stock (C/S) (lowest)

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ShareholderShareholderWealthWealthMaximizationMaximization

(SWM)(SWM)

NOTNOTProfit maximization!

Primary objective of the Primary objective of the financial managerfinancial manager

Primary objective ofPrimary objective offinancial financial

managementmanagement

Shareholder Wealth Maximization

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SWM

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

Is concerned for social responsibility

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Job securityJob security

Management may maximize

its own welfare instead

of the owners’ wealth.

Owners (shareholders)

Management and

Employees

Problem created by separation of

Divergent Objectives create Agency Problems

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Agency Problem: Second Type

Problem created by

separation of

Owners

Creditors

Caused by conflicting interests concerning risk and returns

Protective covenants

in loan agreements

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Agency Costs

Corporate governance Management compensation Threat of takeovers Annual audit by accounting firm

Recent Development:

Sarbanes-Oxley Act

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Shareholder Wealth Maximizing is a Market Concept and Results in Maximizing PV of E(R)

Important note!

Success is measured by Market Value of Common Stock---

Not by profit maximization!

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Limitations of Profit Maximization Static nature of standard microeconomic

model (Lack of time dimension) Variable definition of profit Provides no direct way for managers to

consider the risk of alternative decisions

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Three Basic Factors Determine C/S Market Value 1) Amount of

2) Timing of

3) Risk of

Expected cash flows

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Managers deal with these competitive forces New entrants

Substitute products

Bargaining power of buyers

Bargaining power of suppliers

Rivalry among current competitors

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Cash flow generation

Acquire Assets-Long-term

-Working capital

Produce and SellProducts/Services

Funds for investmentsFunds to distribute

Raise Funds -External-Internal

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Cash Flow Concept central to: Financial analysis Planning Resource allocation

CF does not equal accounting profit

External sources Cash

Internal sources

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NPV of an investment

NPV = PV of future cash flows minus cash outlays

The NPV of an investment represents the contributions of that investment to the value of

the firm and passes on to SWM.

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Controller’s Activities

Financial accounting

Cost accounting

Taxes

Data processing

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Treasurer’s Activities

Management of cash and marketable

securities

Capital budgeting

Financial planning

Credit analysis

Investor relations

Pension fund management

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Professional Organizations Financial Executive Institute

Institute of Charted Financial Analysis

Financial Management Association

Institute of Management Accounting

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Exciting Career Opportunities

VP of Finance

Director Investor Relations

Assistant Treasurer

Tax Manager

Financial Analyst

Account Executive Security Broker

Mortgage Analyst

Banking

Check out http://www.careerpath.com/