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Chapter 1: Introduction to Financial Management

Chapter 1: Introduction to Financial Management. What are 3 “forms” that businesses can take? What are the objectives of these different business forms? What does “maximization of shareholder wealth” mean? How do a company’s “ethics” affect shareholder wealth?

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Chapter 1: Introduction to Financial Management

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  1. Chapter 1: Introduction to Financial Management • What are 3 “forms” that businesses can take? • What are the objectives of these different business forms? • What does “maximization of shareholder wealth” mean? • How do a company’s “ethics” affect shareholder wealth? • How do we measure shareholder wealth? • What are agency conflicts between managers and shareholders? • What are some recent trends that affect businesses? • What do financial managers do within businesses?

  2. What are 3 “forms” that businesses can take? • Sole proprietorship • Text: “An unincorporated business owned by one individual.” • Congratulations! It’s all up to you! • Partnership • Text: “An unincorporated business owned by 2 or more.” • Congratulations! It’s all up to you and your partners! • Corporation • Text: “A legal entity created by a state, separate from its owners and managers.” • Example: GE has 100s of thousands of owners and managers.

  3. Sole Proprietorships and Partnerships • Advantages (versus Corporations) • Easier and cheaper to form • Fewer government regulations • Lower income tax rate • You are your own boss • Disadvantages (versus Corporations) • Unlimited personal liability • Harder to borrow money • When you go, it goes • You are your own boss

  4. Corporations • Advantages (versus Proprietorships and Partnerships) • Liability is limited to what you paid for your shares • Easier to borrow money (“raise capital”) • Easy to transfer ownership (e.g., stock markets) • Distinct from its owners and managers (“unlimited life”) • Disadvantages (versus Proprietorships and Partnerships) • More expensive to form • Many more government regulations • Higher tax rate (dividends are taxed 2x) • “Agency conflicts” between owners and managers

  5. What are the objectives of businesses? Proprietorships and Partnerships • Why might you want to start or own a business? Corporations • Who owns the corporation? • Can you be an owner of Google? • How much of Google would you own if you bought 100 shares? • What do the owners want? • Example: “Buy and hold” investor versus a “Day Trader” • Example: “Growth” stock investor • Example: “Green” stock investor

  6. If you own stock, you are a shareholder. How do we measure “shareholder wealth”? 1) Individual “shareholder wealth” = number of shares x stock price. • What was your shareholder wealth June 17th at 1:00 pm if you own 100 shares of IBM? • $107.32/share x 100 shares. • What is your shareholder wealth right now if you own 100 shares of IBM? 2) Total “shareholder wealth” = shares outstanding x stock price. • There are about 1.34 billion shares of IBM common stock. Calculate the total shareholder wealth of IBM. • $____/share x 1.34 billion shares = $___________ billion. • This is also referred to as the “market capitalization” or “market cap” of IBM. On June 17th at 1 pm, IBM’s market cap was $143.8 billion.

  7. What factors affect stock prices? International Business Machines Corp <IBM.N> contributed the biggest boost to the Dow, jumping nearly 10 percent to $89.82 after the world's top technology services company posted a quarterly profit and a 2009 profit outlook that surpassed Wall Street's expectations. That burst of strength from IBM reassured investors that the Dow component can weather the global economic downturn. Date: Jan. 21,2009, 11:17 PST. http://www.msnbc.msn.com/id/28773170/

  8. What is “maximization of shareholder wealth”? Make the company’s stock price as high as possible! • When? • Short term versus long term decisions • Chevron Example • Investment of $2 billion in offshore oil exploration vs. alternative shale oil research • What about risk? • We’ll talk a lot about different types of risk this semester. Here’s one example: Suppose you buy stock in Wells Fargo because they pay a steady dividend ----- what happens if they cut the dividend?

  9. Los Angeles Times article:January 21, 2009|Tom Petruno http://www.latimes.com/business/la-fi-wells21-2009jan21,0,5780813.story “No happy new year at Wells Fargo as stock dives 52%.” “The banking giant's shares plummet to an 11-year low after an analyst predicts that the company will cut its dividend to bolster its balance sheet.” “Few bank stocks showed the strength that Wells Fargo & Co. did in 2008. This year, few are faring worse than Wells.” “Shares of the San Francisco-based giant Tuesday plummeted $4.45, or 24%, to $14.23, an 11-year low.” [Please note – this was one year ago. Wells Fargo cut dividend from $1.36/shares to $0.20/share. Price now? Check out ticker symbol WFC at finance.yahoo.com or finance.google.com.]

  10. What factors affect stock prices? (cont’d) • Projected cash flows to shareholders (e.g., dividends) • Timing of the cash flows – how soon will they happen? • How certain are the cash flows – what is the “risk” that they will not occur or be smaller or larger than expected?

  11. Do a company’s ethics affect “shareholder wealth”? • Citigroup Example • “Grow aggressively without breaking the law” • In 2007, Citigroup (“C”) traded as high as $55/share. • What is Citigroup’s stock price today? • What major problems have Citigroup and other banks had in the past year? • GE Example • Be a “good citizen” • How has GE’s stock price done since the text was published? • What problems has GE had?

  12. “Intrinsic Value” vs. “Stock Price” – Why does your text emphasize?

  13. How do managers maximize “shareholder wealth”? IN THEORY ----- • In equilibrium, a stock’s price should equal its true (intrinsic) value. • To the extent that investor perceptions are incorrect, a stock’s price in the short run may deviate from its intrinsic value. • Ideally, managers should avoid actions that reduce intrinsic value, even if those decisions increase the stock price in the short run. • Shareholders don’t want managers to take short-term gains and run! • Example: Citigroup’s Director Robert Rubin. $120 million over 10 yrs.

  14. A common exam question for FIN 303: The primary operating goal of a publicly-owned firm interested in serving its stockholders should be to: a. Maximize its expected total corporate income. b. Maximize its expected EPS. c. Minimize the chances of losses. d. Maximize the stock price per share over the long run, which is the stock’s intrinsic value. e. Maximize the stock price on a specific target date. • (Correct Answer: d) • Why is “d” the correct answer?

  15. Another fine exam question for FIN 303: Your best friend is the CEO of Hatho Inc. He just told you that his company will announce next week a huge increase in the quarterly dividend that will surely make the stock price increase next week. He tells you to buy his company’s stock immediately so you can profit. He also tells you not to tell anyone else because only he and the company’s board know about this information. If you buy now, you will be: • Insider trading. • Committing a crime, punishable by prison time. • Committing a crime, punishable by a monetary fine. • Doing something unethical. • All the above. • None of the above. • (Correct Answer: e)

  16. Conflicts Between Managers and Shareholders “Agency conflicts: • Many managers are naturally inclined to act in their own best interests (which are not always the same as the interest of stockholders). How can shareholders affect managerial behavior? • Try to align management and stockholders’ interest • If management benefits when stock holders benefit, they are “aligned” • Examples: • Pay execs at least in part on their “performance” (stock price) • Pay some portion of execs’ compensation in stock and / or options • Direct intervention by shareholders (e.g. Calpers/Goldman) • The threat of firing (e.g. Citigroup’s Director Robert Rubin) • The threat of takeover (e.g. JPM Chase and WAMU)

  17. What are recent trends that affect businesses? • Increased regulation (A very timely topic.) • Text Example: CEOs and CFOs must now certify that their financial statements are accurate – penalties include jail time • Regulation was passed as a result of the Enron mess • Globalization • Corporations increasingly likely to have some production/sales/supplies in other countries • Additional challenges for managing financial and currency risk (euro vs. $ example, IBM example) • Ever improving IT (information technology) • IT innovations include better processes for managing financial data and analyzing projects and risks

  18. Responsibility of the Financial Staff • What do financial managers do within businesses? • Forecasting and planning • Investment and financing decisions • Coordination and control • Transactions in the financial markets • Managing risk

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