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Contemporary Financial Management          Lecture 1:          The Role and Objective of          Financial Management© 20...
Introduction     • This lecture introduces the financial       management process.     • It looks at the financial manager...
Questions Faced in Finance      • How is finance related to other fields of          study?      • What are financial mana...
Forms of Business Organizations     • Sole proprietorship     • Partnership     • Corporation4   © 2004 by Nelson, a divis...
Sole Proprietorship     • Owned by one person     • Represent 75% of all businesses, but accounts         for less than 5%...
Small Business     • Not the dominant firm in the industry     • Tend to grow more rapidly     • Lack management resources...
Partnership     • Owned by two or more persons     • Classified as general or limited                   Advantages        ...
Liability of Partners     • General Partner            Has unlimited liability for all obligations of the            busin...
Limited Partnerships     • Must have at least one general partner who:          • Has unlimited liability          • Perfo...
Corporation      • A distinct, legal entity of its own                    Advantages                                 Disad...
Board of Directors       • Shareholders elect a Board of Directors       • Board of Directors appoints the officers of the...
Who Manages?            Board of Directors           Deals with broad policy               Develops 3-5 year              ...
Shareholder Rights      • Right to share in company profits (or losses)      • Right to vote           • Some shares may b...
Priority of Corporate Securities                      Bonds: Debt securities often backed                             by t...
Type of Organization Influenced by      • Cost      • Complexity      • Liability      • Continuity      • Need for capita...
Shareholder Wealth Maximization      • Core objective of financial managers.      • Considers the timing and risk of the b...
Social Responsibility      • Ethical issues will constantly confront financial          managers as they strive to achieve...
Agency Relationships/Problems                                          Caused by           Owners                        s...
Job Security      • Management’s decisions may be based on          retaining management, rather than Shareholder         ...
Agency Costs      • Costs incurred by shareholders to minimize           agency problems          Examples:           • Ma...
Another Agency Problem                                         Caused by           Owners                                 ...
Examples of Protective Covenants      • Limitations on           • Dividends           • Capital expenditures           • ...
SWM and Profit Maximization      • Shareholder Wealth Maximization is not the          same as Profit Maximization        ...
Maximizing Shareholder Wealth      • To maximize shareholder wealth, the financial          manager must maximize the mark...
Conditions Affecting Market Value                  Factors outside of                 management’s control                ...
Cash Flow      • Cash flows, not accounting profits, are critical to          most financial analysis      • Important cas...
Concept of Net Present Value      • The net present value (NPV) of an investment          represents the contribution of t...
NPV Example      • A firm is analyzing a new investment          opportunity. It can invest $1 million today to          g...
NPV Example: Intuition           0                            1                       2      3        $1 M                ...
NPV Example: Solution          NPV Decision:          Reject the project. Accepting the project will          destroy sign...
Major Points      • Businesses may be established as          proprietorships, partnerships or corporations.      • Shareh...
End of Lecture -132   © 2004 by Nelson, a division of Thomson Canada Limited
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Lecture 1 the role and objective of fm

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  • regarding slides 28-30, since the ROR is factored in to the PV of cash flows, the project should be accepted if NPV is greater than zero. i could be wrong though, just a thought.
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Lecture 1 the role and objective of fm

  1. 1. Contemporary Financial Management Lecture 1: The Role and Objective of Financial Management© 2004 by Nelson, a division of Thomson Canada Limited
  2. 2. Introduction • This lecture 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.2 © 2004 by Nelson, a division of Thomson Canada Limited
  3. 3. 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?3 © 2004 by Nelson, a division of Thomson Canada Limited
  4. 4. Forms of Business Organizations • Sole proprietorship • Partnership • Corporation4 © 2004 by Nelson, a division of Thomson Canada Limited
  5. 5. 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 Funds5 © 2004 by Nelson, a division of Thomson Canada Limited
  6. 6. 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 same6 © 2004 by Nelson, a division of Thomson Canada Limited
  7. 7. Partnership • Owned by two or more persons • Classified as general or limited Advantages Disadvantages Easy Formation Difficult to Raise Funds Taxation occurs at the Partnership Dissolves if level of the partner, not Partner Dies the partnership7 © 2004 by Nelson, a division of Thomson Canada Limited
  8. 8. Liability of Partners • General Partner Has unlimited liability for all obligations of the business • Limited Partner Liability limited to the partnership agreement8 © 2004 by Nelson, a division of Thomson Canada Limited
  9. 9. 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 management9 © 2004 by Nelson, a division of Thomson Canada Limited
  10. 10. Corporation • A distinct, legal entity of its own Advantages Disadvantages Limited Liability Potential for Double Taxation Permanency Some Owners Have Ability to Minimal Control Raise Capital10 © 2004 by Nelson, a division of Thomson Canada Limited
  11. 11. 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 • Secretary11 © 2004 by Nelson, a division of Thomson Canada Limited
  12. 12. 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 decisions12 © 2004 by Nelson, a division of Thomson Canada Limited
  13. 13. 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)13 © 2004 by Nelson, a division of Thomson Canada Limited
  14. 14. Priority of Corporate Securities Bonds: Debt securities often backed by the corporation’s assets. Priority Preferred Stock: non-voting shares that often offer a fixed dividend to shareholders. Common Stock14 © 2004 by Nelson, a division of Thomson Canada Limited
  15. 15. Type of Organization Influenced by • Cost • Complexity • Liability • Continuity • Need for capital • Decision making • Tax considerations15 © 2004 by Nelson, a division of Thomson Canada Limited
  16. 16. 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 responsibility16 © 2004 by Nelson, a division of Thomson Canada Limited
  17. 17. 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 fairly17 © 2004 by Nelson, a division of Thomson Canada Limited
  18. 18. Agency Relationships/Problems Caused by Owners separation of Managers principals Employees Management may attempt to maximize its own welfare instead of the owners’ wealth.18 © 2004 by Nelson, a division of Thomson Canada Limited
  19. 19. 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.19 © 2004 by Nelson, a division of Thomson Canada Limited
  20. 20. 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.20 © 2004 by Nelson, a division of Thomson Canada Limited
  21. 21. Another Agency Problem Caused by Owners separation of Creditors Solution: Creditors insert protective covenants in loan agreements21 © 2004 by Nelson, a division of Thomson Canada Limited
  22. 22. Examples of Protective Covenants • Limitations on • Dividends • Capital expenditures • Incurring additional debt22 © 2004 by Nelson, a division of Thomson Canada Limited
  23. 23. 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 risk23 © 2004 by Nelson, a division of Thomson Canada Limited
  24. 24. 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 stream24 © 2004 by Nelson, a division of Thomson Canada Limited
  25. 25. Conditions Affecting Market Value Factors outside of management’s control Factors within management’s control Conditions in Financial Markets Amount, Timing & Size of Expected Cash Flows Shareholder Wealth (Market Price of the Shares)25 © 2004 by Nelson, a division of Thomson Canada Limited
  26. 26. 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.26 © 2004 by Nelson, a division of Thomson Canada Limited
  27. 27. 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 outflows27 © 2004 by Nelson, a division of Thomson Canada Limited
  28. 28. 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?28 © 2004 by Nelson, a division of Thomson Canada Limited
  29. 29. NPV Example: Intuition 0 1 2 3 $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%.29 © 2004 by Nelson, a division of Thomson Canada Limited
  30. 30. NPV Example: Solution NPV Decision: Reject the project. Accepting the project will destroy significant shareholder value NPV=PV CashInflows -PV Cash Outflows  1- ( 1+r ) -t   1- ( 1+r ) -t  =PMTInflows   -PMTOutflows    r   r       1- ( 1.20 ) -3  =400,000   -1,000,000  0.20    =$842,592330 © 2004 by Nelson, a division of Thomson Canada Limited
  31. 31. 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.31 © 2004 by Nelson, a division of Thomson Canada Limited
  32. 32. End of Lecture -132 © 2004 by Nelson, a division of Thomson Canada Limited

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