Chapter One

1. Chapter One Principles of Finance By Farhana Rob Shampa

2. Definition: What is Finance? “Finance is the methodology of allocating financial resources with a financial value, is an optimal manner to maximize the wealth of a business enterprise.” “ Finance is the process of channeling funds from savers to users in the form of credit, loans or invested capital through agencies including commercial banks savings and loan associations.”

3. Career Opportunities in Finance: • Financial markets • Investments • Managerial finance • Financial institutions • Banks • Insurance companies • Savings and loans • Credit unions

4. The Financial Manager’s Responsibilities: • Obtain and use funds in a way that will maximize the value of the firm: 1. Forecasting and planning. 2. Major investment and financing decisions 3. Coordination and control 4. Dealing with financial markets

5. Finance Function: • 1) Investment Decision. • 2) Financing Decision. • 3) Dividend Decision.

6. Basic Forms of Business Organization: • Sole Proprietorship • Owned by one person, operated for personal profit. • Partnerships • Owned by two or more people, operated for joint profit. • Corporations • “Legal entity”, owned by individuals, operated for joint profit.

7. STRENGTHS: Low organizational cost Income taxed once as personal income Independence Secrecy Ease of dissolution WEAKNESSES: Unlimited liability Limited funding Proprietor must be all Difficult to develop staff career opportunities Lack of continuity on death of proprietor Sole Proprietorship:

8. STRENGTHS: Improved funding sources Increased managerial talent Income split by partnership contract, taxed as personal income WEAKNESSES: Unlimited liability to all partners Partnership dissolved upon death of partner Difficult to liquidate or transfer ownership Partnerships

9. Principles of Finance: • A) Principles of Risk and Return. • B) Principles of Time value of Money • C) Principles of Cash Flow. • D) Principles of Profitability and Liquidity. • E) Principles of Diversity. • F) Hedging Principles.

10. STRENGTHS: Owners’ liability limited Large capitalization possible, greater funding Ownership readily transferable Indefinite life Professional management WEAKNESSES: Higher tax rates Expensive organization Greater government regulation When publicly traded, lacks secrecy Corporations

11. Goal of the Firm /Corporation: • There are two approaches in the corporation goal are: • A) Profit Maximization • B) Wealth Maximization

12. Goal of a Manager • Profit Maximization Or Wealth Maximization

13. Profit Maximization: • Corporations commonly define profit as “Earnings per Share” (EPS). EPS represent the amount of profit earned during the period on behalf of each outstanding share of common stock. (A measure of total earnings divided by total number of ownership shares. )

14. Profit maximization • Profit maximization means maximizing the income of the firm. Profit maximization ensures that firms utilize its resources efficiently. Profit maximization leads to efficiently. Profit maximization leads to efficient allocation of resources. It is a short term view.

15. Profit Maximization: • EPS ignores critical factors of / Limitations of profit maximization are : • It ignores the timing of the returns. • It ignores cash flows available to common shareholders. • It ignores risk factors facing the firm.

16. Shareholder Wealth Maximization:The Goals of the Corporation • Management’ primary goal is stockholder wealth maximization. Shareholder wealth maximization is the value of the firm as measured by the price of the firm’s common stock. • Stock price maximization is the most important goal of most corporations. Shareholder wealth maximization is a more comprehensive goal for the firm, its managers and employees. It is a long term view.

17. Shareholder Wealth Maximization (SWM) • Shareholder Wealth Maximization (SWM) means maximizing owners economic welfare. • Maximizing owners economic welfare is equivalent to Maximizing the utility of their consumption over time. • A firm should be maximize the market value of its shares. Market price of a share is reflection of the firm’s financial performance. • Maximized value of the firm as measured by the price of the firm’s common stock.

18. SWM • Because it (SWM) evaluating Shareholder wealth addresses factors of timing associated with expected earnings per share , cash flows and risk ignored by the EPS. • This can be explored through “economicvalued added” and a focus on stakeholders.

19. Shareholder Wealth Maximization: Financial goal • Wealth maximization is the net present value (or wealth) of a firm. • A financial action which has a positive value creates wealth.

20. Economic Value Added – EVA: • EVA measures whether an investment contributes to shareholder wealth. • EVA is calculated by subtracting cost of funds used from after-tax operating profits. • While popular, EVA is essentially derived from the concept of “net present value.”

21. Stakeholders • Stakeholders include groups that have direct economic links to the firm. • Stakeholders include not only owners, but also employees, customers, suppliers, and creditors. • Maintaining positive stakeholder relationships helps maximize long-term benefits to shareholders.

22. Shareholder Wealth Maximization: • Shareholder Wealth Maximization (SWM) means maximizing owners economic welfare. • Maximizing owners economic welfare is equivalent to Maximizing the utility of their consumption over time. • A firm should be maximize the market value of its shares. Market price of a share is reflection of the firm’s financial performance. • Maximized value of the firm as measured by the price of the firm’s common stock.

23. Rationale Behind Wealth Maximization as the Goal of a Firm: • A) Clear concept. • B) It considers risk, timing of return and time value of money. • C) Focus on market price of share. • D) Economic Vale Addition. • E) Stake holders

24. From the social perspective wealth maximization: • 1) Is to maximize shareholders wealth maximize stock price. • 2) Employee welfare, achieve personal goal. • 3) Ecological/ environment harmony.

25. What about Stakeholders? • Stakeholders include groups that have direct economic links to the firm. • Stakeholders include not only owners, but also employees, customers, suppliers, and creditors. • Maintaining positive stakeholder relationships helps maximize long-term benefits to shareholders.

26. Agency Issues: • An agency relationship exists when one or more people (the principals) hire another person (the agent) to perform a service and then delegate decision-making authority to that agent . The important agency relationship exist : • 1) The principles (share holders ) and the managers. • 2) Stockholders and creditors (debt holders).

27. Agency Issues: The Principal-Agent Problem • Whenever ownership is independent of management there exists potential problem of conflicts. • The owner’s goals for the firm are best described as maximizing shareholder wealth. • Managers are also concerned with personal wealth, job security, lifestyle, and benefits. These concerns may conflict with shareholder interests.

28. Agency Problem: • A potential conflict of interest between: • 1) The principles (share holders ) and the managers. • 2) Stockholders and creditors (debt holders).

29. Agency Problem: • Agency problem the like hood that managers may place personal goals ahead of corporate goals.

30. Ways to motive managers to act in the best interest of shareholders: • 1) The Threat of firing. • 2) The Threat of Takeover. • 3) Structuring Managerial Incentives.

31. 1) The Threat of firing. • Existing share holders attempt of ousted the present management team by stockholders to voting rights and elected new management team.

32. The Threat of firing resistance by present management team: • Current Management attempt of gain control of a firm by soliciting stockholders to vote for a new management team. • It wasn’t long ago that the management teams of large firms felt secure in their positions, because the chances of ousted by being stockholders were so remote that managements rarely felt their jobs are in jeopardy. This situation existed because ownership of most of the

33. Proxy fight: • firms ownership was so widely distributed, and management’s can control over the voting system by proxy (voting) mechanism was so strong, that it was almost impossible for dissident stockholders to gain enough votes to overthrow the managers.

34. 2) The Threat of Takeover. • A) Hostile takeovers: The acquisition of a company over the opposition of its management.

35. The Threat of Takeover.resistance by present management team: • i) Poison Pill. • ii) Green mail.

36. i) Poison Pill. • An action a firm can take that practically kills it and thus to make a firm unattractive to potential buyers and thus to avoid a hostile takeovers. • “If you want to keep control, don’t let your company’s stock sell at a bargain price.”

37. Poison Pill.(Con) • Actions to increase the firm’s stock price and to keep it form being a bargain obviously are good from the standpoint of the stockholders, but other tactics that managers can use to ward off a hostile takeover might not be. • (Golden Parachutes, Golden Handshake)

38. ii) Green mail. • Which is like blackmail. • A situation in which a firm, trying to avoid a takeover, buys back stock at a price above the existing market price from the person (s) trying to gain control of the firm.

39. ii) Green mail. • i) A potential acquirer (firm or individual) buys a block of stock in a company. • ii) The target company’s management becomes frightened that the acquirer will make a tender offer and gain control of the company. • iii) To head off a possible takeover, management offers to pay greenmail, buying the stock owned by the potential

40. ii) Green mail (Con) • Raider at a price above the existing market price without offering the same deal to other stockholders.

41. 3) Structuring Managerial Incentives • Executive compensation packages generally include incentive plans that grant stock options, performance based shares, or cash bonuses upon meeting or exceeding corporate goals. • Such packages may also include long-term benefits that can protect the manager against poor corporate performance.

42. Current View on Incentive Plans: • A type of incentives plan that allows managers to purchase stock at some future time at a given price. • 1) Executive Stock Option. • 2) Performance Share. • 3) Cash Bonus

43. 2) Shareholders versus Creditors: • It stockholders approve actions that harm the position of the firm’s creditors, it is likely that the firm’s creditors, it is likely that the firm will find it difficult to borrow funds in the future.

44. Resolving the Agency Problem • Directors is the heart of any resolution. • 1) Market Forces. • 2) Agency Costs – the costs of this governance: • Monitoring costs, • Structuring compensation costs. • 1) Market Forces : Market forces, such as the potential for hostile takeover provide some deterrence. • Legal forces, fraud, and fiduciary misconduct laws aim to act as deterrents as well.

45. Resolving the Agency Problem: • A) Monitoring costs, B) Structuring compensation costs : 1) Executive Stock Option. • 2) Performance Share. • 3) Cash Bonus

46. Factors Influencing Financial Decisions: • A) Internal Factors. • External Factors.

47. Internal Factors: • 1) Size of the Business. • 2) Nature of Business. • 3) Situation of Business Cycle. • 4) Assets Structure • 5) Terms of Credit. • 6) Management Philosophy.

48. External Factors: • 1) Govt Regulations. • 2) Tax System. • 3) Economic Condition of the Country. • 4) Condition of Money Market & Capital Market.

49. Questions: • 1) Define what is Finance? • 2) What role should financial managers play in the modern enterprise? • 3) Write down the function of Finance? • 4) In what way is the wealth maximization objectives superior to the profit maximization? Explain • 5) What is management’ primary goal?