Gsb711 Lecture note 01 Introduction to Managerial Finance
Introduction to Managerial Finance<br />Topic 01<br />GSB711 – Managerial Finance<br />Readings:<br />From Corporate Finance Principles and Decision-Making:<br />Overview of Corporate Finance: Principles and Decision-Making (Pages 1 - 6)<br />Chapter: Goals and Governance of the firm (Page 8 – 34) <br />Case Study: Ethics in Finance (Pages 36 – 51)<br />
Important Issues<br />What is managerial or corporate finance?<br />How is (managerial / corporate) finance different from accounting? <br />What are different forms of business organization? <br />Forms of business organization<br />What are the goals of corporate firms?<br />Goals / objectives of corporate firms<br />What are the important financial decisions that are made in corporate firms? <br />Financial decisions in a corporate firm<br />What is agency cost and how does it impact financial decisions? <br />
What is managerial finance?<br />Managerial finance is commonly known as corporate finance<br />It deals with the financing decisions made in any organization on a commercial basis<br />Firms (or business entities) employ real assets and other resources to produce outputs (which may be products or services)<br />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. <br />
How is (managerial / corporate) finance different from accounting? <br />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. <br />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. <br />Finance is therefore completely different from accounting though we rely on financial statements for important financial decisions. <br />
Before we examine financial decisions<br />We try and distinguish different forms of business organization. <br />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. <br />Let us look at different forms of business organisations<br />
Forms of business organization<br />Individuals or families may organize their business in such a way where there is no separation of personal and business interests <br />We call this form as sole proprietorship<br />Partnerships on the other hand involve more than one individual (one family). Again personal and business interests are not completely separated<br />These two forms have existed from time unknown. <br />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 <br />
Sole Proprietorship<br />Advantages<br />Easiest to start<br />Least regulated<br />Single owner keeps all the profits<br />Taxed once as personal income<br />Disadvantages<br />Limited to life of owner<br />Equity capital limited to owner’s personal wealth<br />Unlimited liability<br />Difficult to sell ownership interest<br />
Partnership<br />Advantages<br />Two or more owners<br />More capital available<br />Relatively easy to start<br />Income taxed once as personal income<br />Disadvantages<br />Unlimited liability<br />General partnership<br />Limited partnership<br />Partnership dissolves when one partner dies or wishes to sell<br />Difficult to transfer ownership<br />
Corporation<br />Advantages<br />Limited liability<br />Unlimited life<br />Separation of ownership and management<br />Transfer of ownership is easy<br />Easier to raise capital<br />Disadvantages<br />Separation of ownership and management<br />Double taxation (income taxed at the corporate rate and then dividends taxed at the personal rate)<br />
We will focus more on corporations in the remainder of the unit<br />Please note the principles or frameworks we learn in this unit have wide applications beyond corporate form of organization<br />As long as we are clear about the objective of a specific organization we can easily tweak the frameworks to attain these objectives<br />
Goals / objectives of corporate firms<br /><ul><li>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. </li></li></ul><li>Goals / objectives of corporate firms<br /><ul><li>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. </li></li></ul><li>Why traditional corporate financial theory often focuses on maximizing stock prices as opposed to firm value<br />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).<br />If investors are rational (are they?), stock prices reflect the wisdom of decisions, short term and long term, instantaneously.<br />The stock price is a real measure of stockholder wealth, since shareholders can sell their stock and receive the price now.<br />
Maximize stock prices as the only objective function<br />For stock price maximization to be the only objective in decision making, we have to assume that<br />The decision makers (managers) are responsive to the owners (shareholders) of the firm<br />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.<br />Markets are efficient; only then will stock prices reflect stockholder wealth.<br />There are no significant social costs; only then will firms maximizing value be consistent with the welfare of all of society.<br />
(1)<br />(2)<br />(4a)<br />(4b)<br />(3)<br />(1) Cash raised from investors<br />(2) Cash invested in firm<br />(3) Cash generated by operations<br />(4a) Cash reinvested<br />(4b) Cash returned to investors<br />The Role of The Financial Manager<br />Firm's<br />Financial<br />operations<br />Investors<br />Manager<br />Investment assets<br />Real assets<br />
The Role of The Financial Manager<br />Real Assets<br />Assets used to produce goods and services.<br />Financial Assets<br />Financial claims to the income generated by the firm’s real assets.<br />
Who is The Financial Manager?<br />Chief Financial Officer<br />Treasurer<br />Controller<br />
Who is The Financial Manager?<br /><ul><li>Chief Financial Officer (CFO)
Oversees the treasurer and controller and sets overall financial strategy.
Responsible for budgeting, accounting, and taxes.</li></li></ul><li>First Principles of Corporate / Managerial Finance<br />Invest in projects that yield a return greater than the minimum acceptable hurdle rate.<br />The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt)<br />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.<br />Choose a financing mix that minimizes the hurdle rate and matches the assets being financed.<br />If there are not enough investments that earn the hurdle rate, return the cash to shareholders.<br /> The form of returns - dividends and stock buybacks - will depend upon the shareholders’ characteristics.<br />Objective: Maximize the Value of the Firm<br />
Some important questions that are answered using finance<br />What long-term investments should the firm take on?<br />Where will we get the long-term financing to pay for the investment?<br />How much debt a firm needs to employ?<br />How much dividend to pay to shareholders or how much stock to buyback?<br />How will we manage the everyday financial activities of the firm?<br />
Agency cost<br />Agency relationship<br />Principal hires an agent to represent his/her interest<br />shareholders (principals) hire managers (agents) to run the company<br />
The Agency Cost Problem<br />The interests of managers, shareholders, bondholders and society can diverge. What is good for one group may not necessarily for another.<br />Managers may have other interests (job security, perks, compensation) that they put over stockholder wealth maximization.<br />Actions that make shareholders better off (increasing dividends, investing in risky projects) may make bondholders worse off.<br />Actions that increase stock price may not necessarily increase stockholder wealth, if markets are not efficient or information is imperfect.<br />Actions that makes firms better off may create such large social costs that they make society worse off.<br />Agency costs refer to the conflicts of interest that arise between all of these different groups.<br />
What can go wrong?<br />SHAREHOLDERS<br />Managers put<br />their interests<br />above shareholders<br />Have little control<br />over managers<br />Significant Social Costs<br />Lend Money<br />Managers<br />BONDHOLDERS<br />SOCIETY<br />Bondholders can<br />get ripped off<br />Some costs cannot be<br />traced to firm<br />Delay bad<br />news or <br />provide <br />misleading<br />information<br />Markets make<br />mistakes and<br />can over react<br />FINANCIAL MARKETS<br />
I. Stockholder Interests vs. Management Interests<br />Theory: The shareholders have significant control over management. The mechanisms for disciplining management are the annual meeting and the board of directors. <br />Practice: Neither mechanism is as effective in disciplining management as theory posits.<br />
The Annual Meeting as a disciplinary venue<br />The power of shareholders to act at annual meetings is diluted by three factors <br />Most small shareholders do not go to meetings because the cost of going to the meeting exceeds the value of their holdings.<br />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.<br />For large shareholders, the path of least resistance, when confronted by managers that they do not like, is to vote with their feet.<br />
Directors lack the expertise to ask the necessary tough questions..<br />The CEO sets the agenda, chairs the meeting and controls the information.<br />The search for consensus overwhelms any attempts at confrontation.<br />
II. Shareholders' objectives vs. Bondholders' objectives<br /><ul><li>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.</li></li></ul><li>Aligning interests<br />Managerial compensation<br />Incentives can be used to align management and stockholder interests<br />The incentives need to be structured carefully to make sure that they achieve their goal<br />Corporate control<br />The threat of a takeover may result in better management<br />Other stakeholders<br />
Some important questions<br />What are the types of financial management decisions and what questions are they designed to answer?<br />What are the three major forms of business organization?<br />What is the goal of financial management?<br />What are agency problems and why do they exist within a corporation?<br />