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© 2004 by Nelson, a division of Thomson Canada Limited
Chapter 1:The Role and Objective ofFinancial Management
Contemporary Financial Management
© 2004 by Nelson, a division of Thomson Canada Limited2
Introduction
This chapter introduces the financial management process. It looks at the financial manager, the field of finance, financial decisions and their implications, and the daily questions faced by the firm’s financial management.
© 2004 by Nelson, a division of Thomson Canada Limited3
Questions Faced in Finance
How is finance related to other fields of study?
What are financial managers’ goals and objectives?
How has the finance field evolved?
How is the finance field changing today?
© 2004 by Nelson, a division of Thomson Canada Limited4
Forms of Business Organizations
Sole proprietorship
Partnership
Corporation
© 2004 by Nelson, a division of Thomson Canada Limited5
Sole Proprietorship
Owned by one person
Represent 75% of all businesses, but accounts for less than 5% of dollar volume.
Advantages Disadvantages
Easy Formation Unlimited Liability
Difficult to Raise Funds
© 2004 by Nelson, a division of Thomson Canada Limited6
Small Business
Not the dominant firm in the industry
Tend to grow more rapidly
Lack management resources
Have a high failure rate
Shares not publicly traded
Poorly diversified
Owner/manager frequently the same
© 2004 by Nelson, a division of Thomson Canada Limited7
Partnership
Owned by two or more persons
Classified as general or limited
Advantages Disadvantages
Easy Formation Difficult to Raise Funds
Partnership Dissolves if Partner Dies
Taxation occurs at the level of the partner, not
the partnership
© 2004 by Nelson, a division of Thomson Canada Limited8
Liability of Partners
General PartnerHas unlimited liability for all obligations of the business
Limited PartnerLiability limited to the partnership agreement
© 2004 by Nelson, a division of Thomson Canada Limited9
Limited Partnerships
Must have at least one general partner who: Has unlimited liability Performs all management functions
Can have many limited partners who: Have limited liability Cannot participate in management
© 2004 by Nelson, a division of Thomson Canada Limited10
Corporation
A distinct, legal entity of its own
Advantages Disadvantages
Limited Liability
Permanency
Ability to Raise Capital
Potential for Double Taxation
Some Owners HaveMinimal Control
© 2004 by Nelson, a division of Thomson Canada Limited11
Board of Directors
Shareholders elect a Board of Directors
Board of Directors appoints the officers of the company:
Chairman of the board Chief executive officer (CEO) Chief operating officer (COO) President Chief financial officer (CFO) Vice president Treasurer Secretary
© 2004 by Nelson, a division of Thomson Canada Limited12
Who Manages?
Board of Directors
Deals with broad policy
Develops 3-5 year strategic plan
Management
Responsible for implementing strategic plan
Makes day-to-day management decisions
© 2004 by Nelson, a division of Thomson Canada Limited13
Shareholder Rights
Right to share in company profits (or losses)
Right to vote Some shares may be non-voting Some shares may carry multiple votes
Right to share in the residual assets at dissolution
Right to acquire new common stock (preemptive right)
© 2004 by Nelson, a division of Thomson Canada Limited14
Priority of Corporate Securities
Bonds: Debt securities often backed by the corporation’s assets.
Preferred Stock: non-voting shares that often offer a fixed dividend to shareholders.
Common Stock
Pri
ori
ty
© 2004 by Nelson, a division of Thomson Canada Limited15
Type of Organization Influenced by
Cost
Complexity
Liability
Continuity
Need for capital
Decision making
Tax considerations
© 2004 by Nelson, a division of Thomson Canada Limited16
Shareholder Wealth Maximization
Core objective of financial managers.
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
© 2004 by Nelson, a division of Thomson Canada Limited17
Social Responsibility
Ethical issues will constantly confront financial managers as they strive to achieve the goal of Shareholder Wealth Maximization
Managers must: Avoid personal conflicts of interest Maintain confidentiality Be objective Act fairly
© 2004 by Nelson, a division of Thomson Canada Limited18
Agency Relationships/Problems
OwnersOwners ManagersEmployeesManagersEmployees
Management may attempt to maximizeits own welfare instead of the owners’ wealth.
Management may attempt to maximizeits own welfare instead of the owners’ wealth.
Caused by separation of
principals
Caused by separation of
principals
© 2004 by Nelson, a division of Thomson Canada Limited19
Job Security
Management’s decisions may be based on retaining management, rather than Shareholder Wealth Maximization
Example: A decision is made to retain an existing supplier
rather than select a new supplier providing higher quality and/or lower cost
Why? If a change is made management will be scrutinized, but if no change is made, the issue will be ignored.
© 2004 by Nelson, a division of Thomson Canada Limited20
Agency Costs
Costs incurred by shareholders to minimize agency problems
Examples: Management incentives Monitor performance Owners protection Complex organization structures
Recent Trend: flatter organizational structures have emerged to reduce costs.
© 2004 by Nelson, a division of Thomson Canada Limited21
Another Agency Problem
OwnersOwners CreditorsCreditorsCaused by separation ofCaused by
separation of
Solution:Creditors insert protective covenants in
loan agreements
Solution:Creditors insert protective covenants in
loan agreements
© 2004 by Nelson, a division of Thomson Canada Limited22
Examples of Protective Covenants
Limitations on
Dividends Capital expenditures Asset divestitures Incurring additional debt Poison pills
© 2004 by Nelson, a division of Thomson Canada Limited23
SWM and Profit Maximization
Shareholder Wealth Maximization is not the same as Profit Maximization
Reasons: Profit maximization has no time dimension Profit is an accounting concept with many
different interpretations Profit maximization ignores risk
© 2004 by Nelson, a division of Thomson Canada Limited24
Maximizing Shareholder Wealth
To maximize shareholder wealth, the financial manager must maximize the market value of the firm’s common stock
Three factors determine the market value of common stock: Size of the firm’s cash flow Timing of the firm’s cash flow Risk of the firm’s cash flow stream
© 2004 by Nelson, a division of Thomson Canada Limited25
Conditions Affecting Market Value
Conditions in Financial
Markets
Factors outside of management’s control
Amount, Timing & Size of Expected Cash Flows
Shareholder Wealth (Market Price of the Shares)
Factors within management’s control
© 2004 by Nelson, a division of Thomson Canada Limited26
Cash Flow
Cash flows, not accounting profits, are critical to most financial analysis
Important cash flow concepts: Timing of cash inflows versus cash outflows Cash flow is not equal to operating profit.
© 2004 by Nelson, a division of Thomson Canada Limited27
Concept of Net Present Value
The net present value (NPV) of an investment represents the contribution of the investment to the value of the firm
To maximize shareholder wealth, reject all projects with a negative NPV
NPV = PV of cash inflows - PV of cash outflows
© 2004 by Nelson, a division of Thomson Canada Limited28
NPV Example
A firm is analyzing a new investment opportunity. It can invest $1 million today to generate free cash flows of $400,000 per year for the next three years. After three years, the project is worthless. The firm’s shareholders require a 20% return. Should they proceed?
© 2004 by Nelson, a division of Thomson Canada Limited29
NPV Example: Intuition
0 321
$1 M $400K $400K $400K
Solution is calculated by discount each of the cash flows back to time period zero using a
discount rate of 20%.
© 2004 by Nelson, a division of Thomson Canada Limited30
NPV Example: Solution
-t -t
Inflows Outflows
-3
NPV=PV CashInflows- PV CashOutflows
1- 1+r 1- 1+r=PMT -PMT
r r
1- 1.20=400,000 -1,000,000
0.20
=$842,5923
NPV Decision:
Reject the project. Accepting the project will destroy significant shareholder value
© 2004 by Nelson, a division of Thomson Canada Limited31
Major Points
Businesses may be established as proprietorships, partnerships or corporations.
Shareholders are entitled to a number of rights as owners of a corporation.
The separation between shareholders, managers and creditors give rise to agency problems which detract from a firm’s goal of shareholder wealth maximization.
Positive NPV projects enhance shareholder wealth.