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Gsb711 Lecture note 01   Introduction to Managerial Finance
 

Gsb711 Lecture note 01 Introduction to Managerial Finance

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An Introduction to Managerial Finance prepared for the Graduate School of Business at the University of New England. Slides prepared by Dr Subba Reddy Yarram.

An Introduction to Managerial Finance prepared for the Graduate School of Business at the University of New England. Slides prepared by Dr Subba Reddy Yarram.

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    Gsb711 Lecture note 01   Introduction to Managerial Finance Gsb711 Lecture note 01 Introduction to Managerial Finance Presentation Transcript

    • Introduction to Managerial Finance
      Topic 01
      GSB711 – Managerial Finance
      Readings:
      From Corporate Finance Principles and Decision-Making:
      Overview of Corporate Finance: Principles and Decision-Making (Pages 1 - 6)
      Chapter: Goals and Governance of the firm (Page 8 – 34)
      Case Study: Ethics in Finance (Pages 36 – 51)
    • Important Issues
      What is managerial or corporate finance?
      How is (managerial / corporate) finance different from accounting?
      What are different forms of business organization?
      Forms of business organization
      What are the goals of corporate firms?
      Goals / objectives of corporate firms
      What are the important financial decisions that are made in corporate firms?
      Financial decisions in a corporate firm
      What is agency cost and how does it impact financial decisions?
    • What is managerial finance?
      Managerial finance is commonly known as corporate finance
      It deals with the financing decisions made in any organization on a commercial basis
      Firms (or business entities) employ real assets and other resources to produce outputs (which may be products or services)
      Finance helps firms to acquire real assets and other factors of production. This is a very limited view of finance. In reality finance function is much broader in scope where financial managers are called upon to make important decisions that relate to (i) selection of important investments; (ii) ways in which businesses can secure necessary capital; (ii) structuring of capital into equity and debt and other sources; and (iv) payout of dividends or buyback of shares.
    • How is (managerial / corporate) finance different from accounting?
      Accounting provides an important function in that all use of resources are clearly accounted for as per agreed upon standards. Very often the financial reports that are produced as part of accounting are historical in nature.
      Finance on the other hand relies to a great extent on markets for all financial decisions. We will clarify this more in future topics. The most important financial statement that finance relies of the 3 is the cash flow statement as the other two statements – balance sheet and income statement suffer from historical bias and accounting judgements respectively.
      Finance is therefore completely different from accounting though we rely on financial statements for important financial decisions.
    • Before we examine financial decisions
      We try and distinguish different forms of business organization.
      Most of the financial decision that we will be dealing in this unit are equally applicable to all forms of business or non-business organizations as long as the objective of these organizations is to create sustainable value.
      Let us look at different forms of business organisations
    • Forms of business organization
      Individuals or families may organize their business in such a way where there is no separation of personal and business interests
      We call this form as sole proprietorship
      Partnerships on the other hand involve more than one individual (one family). Again personal and business interests are not completely separated
      These two forms have existed from time unknown.
      Corporate form of business organisations (or usually known as firms / companies) are of relatively recent phenomenon where there is a strict legal separation of personal and business interest. Limited liability is a great distinguishing factor which makes it easy to transfer ownership from individual (or institution) to another
    • Sole Proprietorship
      Advantages
      Easiest to start
      Least regulated
      Single owner keeps all the profits
      Taxed once as personal income
      Disadvantages
      Limited to life of owner
      Equity capital limited to owner’s personal wealth
      Unlimited liability
      Difficult to sell ownership interest
    • Partnership
      Advantages
      Two or more owners
      More capital available
      Relatively easy to start
      Income taxed once as personal income
      Disadvantages
      Unlimited liability
      General partnership
      Limited partnership
      Partnership dissolves when one partner dies or wishes to sell
      Difficult to transfer ownership
    • Corporation
      Advantages
      Limited liability
      Unlimited life
      Separation of ownership and management
      Transfer of ownership is easy
      Easier to raise capital
      Disadvantages
      Separation of ownership and management
      Double taxation (income taxed at the corporate rate and then dividends taxed at the personal rate)
    • We will focus more on corporations in the remainder of the unit
      Please note the principles or frameworks we learn in this unit have wide applications beyond corporate form of organization
      As long as we are clear about the objective of a specific organization we can easily tweak the frameworks to attain these objectives
    • Goals / objectives of corporate firms
      • What should be the goal of a corporation?
      • It is important to recognize the changing paradigm in relation to the goals or objectives of corporate firms. The traditional view is that corporations are ‘owned’ by shareholders and that corporate firms should pursue in maximizing the wealth of shareholders.
      • This view has been rightly questioned in the last 3 decades or so.
      • Corporations (companies) have assumed great control of societal resources and are therefore responsible for the entire society
      • Shareholders obviously are important as they provide the necessary risk capital on a perpetual basis.
      • Employees are very important as their lives are intertwined with that of the business and the sustainability of the business is important for them as their reputational capital and future entitlements are often dependent on the success of businesses.
      • Suppliers have relationships that are important for them
      • Lenders are important as they provide risk capital with varying time commitments. They also provide disciplinary benefits through their monitoring of business activities.
      • Customers satisfaction is important and very often customers have future commitments from firms.
      • Governments provide the necessary legal and regulatory framework and as we have seen in the recent global financial crisis (GFC) acted as the lender of last resort.
    • Goals / objectives of corporate firms
      • While we are conscious of social responsibility considerations, for corporate firms to sustain themselves in the long run, they should enhance shareholder wealth
      • Does this mean we should do anything and everything to maximize owner wealth?
      • Wealth maximization occurs when firms pursue policies that sustain economic, social and environmental interests for the entire society
      • Often in the short-term, opportunities may exist to make economic profits by exploiting social and environmental resources, but pursuit of these would invariably lead to sub-optimal outcomes for stakeholders in the long run and this in turn affects value or wealth maximization.
    • Why traditional corporate financial theory often focuses on maximizing stock prices as opposed to firm value
      Stock price is easily observable and constantly updated (unlike other measures of performance, which may not be as easily observable, and certainly not updated as frequently).
      If investors are rational (are they?), stock prices reflect the wisdom of decisions, short term and long term, instantaneously.
      The stock price is a real measure of stockholder wealth, since shareholders can sell their stock and receive the price now.
    • Maximize stock prices as the only objective function
      For stock price maximization to be the only objective in decision making, we have to assume that
      The decision makers (managers) are responsive to the owners (shareholders) of the firm
      Stockholder wealth is not being increased at the expense of bondholders and lenders to the firm; only then is stockholder wealth maximization consistent with firm value maximization.
      Markets are efficient; only then will stock prices reflect stockholder wealth.
      There are no significant social costs; only then will firms maximizing value be consistent with the welfare of all of society.
    • The Classical Objective Function
      SHAREHOLDERS
      Hire & fire
      managers
      - Board
      - Annual Meeting
      Maximize
      stockholder wealth
      No Social Costs
      Lend Money
      Managers
      BONDHOLDERS
      SOCIETY
      Protect
      bondholder
      Interests
      Costs can be
      traced to firm
      Reveal
      information
      honestly and
      on time
      Markets are
      efficient and
      assess effect on
      value
      FINANCIAL MARKETS
    • Another Way of Presenting this is...
    • Another Way of Presenting this is...
    • Financial decisions in a corporate firm
      Four major long-term decisions
      Investment decision
      Financing decision
      Capital structure decision
      Dividend decision
      Short-term financial decisions
      Working capital management
      Receivables
      Payables
      Cash
      Inventory
    • The Traditional Accounting Balance Sheet
    • The Financial View of the Firm
    • (1)
      (2)
      (4a)
      (4b)
      (3)
      (1) Cash raised from investors
      (2) Cash invested in firm
      (3) Cash generated by operations
      (4a) Cash reinvested
      (4b) Cash returned to investors
      The Role of The Financial Manager
      Firm's
      Financial
      operations
      Investors
      Manager
      Investment assets
      Real assets
    • The Role of The Financial Manager
      Real Assets
      Assets used to produce goods and services.
      Financial Assets
      Financial claims to the income generated by the firm’s real assets.
    • Who is The Financial Manager?
      Chief Financial Officer
      Treasurer
      Controller
    • Who is The Financial Manager?
      • Chief Financial Officer (CFO)
      • Oversees the treasurer and controller and sets overall financial strategy.
      • Treasurer
      • Responsible for financing, cash management, and relationships with banks and other financial institutions.
      • Controller
      • Responsible for budgeting, accounting, and taxes.
    • First Principles of Corporate / Managerial Finance
      Invest in projects that yield a return greater than the minimum acceptable hurdle rate.
      The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt)
      Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.
      Choose a financing mix that minimizes the hurdle rate and matches the assets being financed.
      If there are not enough investments that earn the hurdle rate, return the cash to shareholders.
      The form of returns - dividends and stock buybacks - will depend upon the shareholders’ characteristics.
      Objective: Maximize the Value of the Firm
    • Some important questions that are answered using finance
      What long-term investments should the firm take on?
      Where will we get the long-term financing to pay for the investment?
      How much debt a firm needs to employ?
      How much dividend to pay to shareholders or how much stock to buyback?
      How will we manage the everyday financial activities of the firm?
    • Agency cost
      Agency relationship
      Principal hires an agent to represent his/her interest
      shareholders (principals) hire managers (agents) to run the company
    • The Agency Cost Problem
      The interests of managers, shareholders, bondholders and society can diverge. What is good for one group may not necessarily for another.
      Managers may have other interests (job security, perks, compensation) that they put over stockholder wealth maximization.
      Actions that make shareholders better off (increasing dividends, investing in risky projects) may make bondholders worse off.
      Actions that increase stock price may not necessarily increase stockholder wealth, if markets are not efficient or information is imperfect.
      Actions that makes firms better off may create such large social costs that they make society worse off.
      Agency costs refer to the conflicts of interest that arise between all of these different groups.
    • What can go wrong?
      SHAREHOLDERS
      Managers put
      their interests
      above shareholders
      Have little control
      over managers
      Significant Social Costs
      Lend Money
      Managers
      BONDHOLDERS
      SOCIETY
      Bondholders can
      get ripped off
      Some costs cannot be
      traced to firm
      Delay bad
      news or
      provide
      misleading
      information
      Markets make
      mistakes and
      can over react
      FINANCIAL MARKETS
    • I. Stockholder Interests vs. Management Interests
      Theory: The shareholders have significant control over management. The mechanisms for disciplining management are the annual meeting and the board of directors.
      Practice: Neither mechanism is as effective in disciplining management as theory posits.
    • The Annual Meeting as a disciplinary venue
      The power of shareholders to act at annual meetings is diluted by three factors
      Most small shareholders do not go to meetings because the cost of going to the meeting exceeds the value of their holdings.
      Incumbent management starts off with a clear advantage when it comes to the exercising of proxies. Proxies that are not voted becomes votes for incumbent management.
      For large shareholders, the path of least resistance, when confronted by managers that they do not like, is to vote with their feet.
    • Directors lack the expertise to ask the necessary tough questions..
      The CEO sets the agenda, chairs the meeting and controls the information.
      The search for consensus overwhelms any attempts at confrontation.
    • II. Shareholders' objectives vs. Bondholders' objectives
      • In theory: there is no conflict of interests between shareholders and bondholders.
      • In practice: shareholders may maximize their wealth at the expense of bondholders.
      • Increasing dividends significantly: When firms pay cash out as dividends, lenders to the firm are hurt and shareholders may be helped. This is because the firm becomes riskier without the cash.
      • Taking riskier projects than those agreed to at the outset: Lenders base interest rates on their perceptions of how risky a firm’s investments are. If shareholders then take on riskier investments, lenders will be hurt.
      • Borrowing more on the same assets: If lenders do not protect themselves, a firm can borrow more money and make all existing lenders worse off.
    • Aligning interests
      Managerial compensation
      Incentives can be used to align management and stockholder interests
      The incentives need to be structured carefully to make sure that they achieve their goal
      Corporate control
      The threat of a takeover may result in better management
      Other stakeholders
    • Some important questions
      What are the types of financial management decisions and what questions are they designed to answer?
      What are the three major forms of business organization?
      What is the goal of financial management?
      What are agency problems and why do they exist within a corporation?