Introduction to Managerial Finance

1. Introduction to Managerial Finance An Overview of Managerial Finance Besley: Chapter 1

2. Career Opportunities in Finance Finance consists of three interrelated areas: • Financial Markets & Institutions • Focus on Macroeconomic Issues • Investments • Focus on Portfolio & Individual Securities Decision Structure • Managerial Finance • “Business Finance” concerned with Managing the Firm Besley Ch. 1

3. The Globalization of Business Four factors influencing the trend toward globalization: • The world has become smaller. • Advancements in transportation and communications have lowered shipping costs and expended the feasibility of international trade. • Consumer desire for low-cost; high-quality products has lowered trade barriers which have traditionally protected inefficient domestic manufacturers. Besley Ch. 1

4. The Globalization of Business Four factors influencing the trend toward globalization: • Firms seeking to expand into new markets to increase unit sales find opportunities abroad. • As more multinationals operate in countries with lower costs, non-multinationals are forced to follow the trend or find other ways to compete. Besley Ch. 1

5. The Financial Manager’s Responsibility Financial managers are responsible for making decision regarding the use of the firm’s funds. These activities include: • Forecasting & Planning • Major investment and financing decision • Coordination and Control • Dealing with the financial markets Besley Ch. 1

6. Alternative Forms of Business Organization There are three main forms of business organization: • Proprietorships • Partnerships • Corporations Besley Ch. 1

7. Advantages Easily and inexpensively formed Low government regulations Taxed at the individual level; not corporate level Limitations Unlimited personal liabilities Limited life Difficulty transferring ownership Limited access to capital Proprietorship Proprietorship: An unincorporated business owned by one individual. Besley Ch. 1

8. Advantages Easily and inexpensively formed Low government regulations Taxed at the individual level; not corporate level Limitations Unlimited personal liabilities Limited life Difficulty transferring ownership Limited access to capital Partnership Partnership: An unincorporated business owned by two or more individuals. Besley Ch. 1

9. Advantages Unlimited life Easy transfer of ownership Limited Liability Limitations Double taxation of corporate earnings Complexity and cost of incorporation Corporation Corporation: A legal entity created by a state, separate and distinct from its owners and managers, having unlimited life. Besley Ch. 1

10. Finance in the Organizational Structure of the Firm Board of Directors President Vice-President: Sales Vice-President: Finance Vice-President: Manufacturing Treasurer Controller Credit Manager Inventory Manager Director of Capital Budgeting Cost Accounting Financial Accounting Tax Department Besley Ch. 1

11. Goals of the Corporation Primary Goal of Management is to maximize stockholder wealth. Wealth maximization is measured by the value of the corporations common stock. Besley Ch. 1

12. Shareholder Actions/Expectations Hire management team that will maximize wealth. Management Team Actions Reasonable Rates of Return/Normal Profits Personal interests/goals Higher Salary Employee Benefits/Perks Other Interests Managerial Incentives to Maximize Shareholder Wealth Besley Ch. 1

13. Social Responsibility Are firms responsible for the well-being of their employees, customers and communities? Social responsibilities have associated costs which oppose wealth maximization. Government Regulation. Besley Ch. 1

14. Stock Price Maximization and Social Welfare Stock price maximization is good since it leads to: • Efficient operations that produce high-quality goods at low consumer prices. • Fulfilling consumer demand (society needs) with new products/services. Besley Ch. 1

15. Managerial Actions to Maximize Shareholder Wealth Management should focus on earnings per share (EPS) rather than total corporate profits. XEROX Current Expansion* Sh. Outstanding: 300Mil. 600Mil. Net Profit: $1,200Mil. $1,500Mil. EPS $4 $2.50 * Assume that Xerox decided to issue an additional 300million shares and invested the funds in business that produced profits of $300million. Besley Ch. 1

16. Managerial Actions to Maximize Shareholder Wealth Other factors to consider in EPS maximization: • Timing of Earnings • Risk • Capital Structure Besley Ch. 1

17. Project A Expected Change in EPS: Year 1: $0.20 Year 2: $0.20 Year 3: $0.20 Year 4: $0.20 Year 5: $0.20 TOTAL: $1.00 Project B Expected Change in EPS: Year 1: $0.00 Year 2: $0.00 Year 3: $0.00 Year 4: $0.00 Year 5: $1.25 TOTAL: $1.25 Timing of Earnings Besley Ch. 1

18. Risk Risk inherent in the predictability of the projected EPS. • Given two projects with equal EPS impact, a firm would choose the one with less risk. Besley Ch. 1

19. Capital Structure Greater the use of Debt – Greater the threat of bankruptcy. • While debt financing increases EPS, it also increases the risk associated with those earnings. Besley Ch. 1

20. Dividend Policy Dividend Policy Decision: The decision as to how much of current earnings to pay out as dividends rather than retain for reinvestment in the firm. Besley Ch. 1

21. Firm’s Stock Price A firm’s stock price is determined by the following factors: • Projected Earnings per Share • Timing of the Earnings Stream • Predictability (risk) of projected earnings • Use of debt • Dividend Policy • Market Conditions Besley Ch. 1

22. Agency Relationships Agency Relationship: a relationship in which one or more people (principals) delegate certain decision making authority another (agent). Examples of agency relationships are: • Stockholders and Managers • Stockholders and creditors (debtholders) Besley Ch. 1

23. Agency Relationships Agency Problem: Is the potential for a conflict of interests between the shareholders (principals) and (1) the firm’s managers, or (2) creditors. Besley Ch. 1

24. Stockholders versus Managers Managers are naturally inclined to act in their own best interests. Methods of Motivating Managers: • Threat of firing. • Threat of hostile takeover. • Defense Mechanisms: • Poison Pill Examples: • “Golden Parachutes” • Disney sale of large blocks of stock at low prices to “friendly” investors. • Scott Industries’ plan to make all debt immediately payable. • Greenmail Besley Ch. 1

25. Stockholders versus Managers Methods of Motivating Managers: • Management Compensation/Incentives • Performance Based Compensation packages: • Executive Stock Options • Performance Shares • Profit-Based Bonus’ Besley Ch. 1

26. Stockholders versus Creditors Creditors lend funds to the firm at rates that are based on: • The riskiness of the firm’s existing assets; • Expectations concerning the riskiness of future asset additions; • The firm’s existing capital structure; and • Expectations concerning future capital structure changes. Besley Ch. 1

27. Stockholders versus Creditors • Shareholders (through managers) could take actions to maximize stock price that are detrimental to creditors. • In the long run, such actions will raise the cost of debt and ultimately lower stock price. Besley Ch. 1

28. The External Environment Summary of Major Factors Affecting Stock Prices Strategic Policy Decisions Controlled by Management 1. Types of Products and Services Produced 2. Production Methods Used 3. Relative Use of Debt Financing 4. Dividend policy External Constraints: 1. Antitrust Laws 2. Environmental Regulations 3. Product and Workplace Safety Regulations 4. Employment Practices Rules 5. Federal Reserve Policy 6. International Developments Level of Economic Activity and Corporate Taxes Stock Market Conditions Expected Profitability Stock Price Timing of Cash Flows Degrees of Risk Besley Ch. 1

29. Business Ethics Most executives believe that there is a positive correlation between ethics and long-run profitability because ethical behavior: • Avoids fines and legal expenses • Builds public trust • Attracts business from customers who appreciate and support its policies • Attracts and keeps employees of the highest caliber, and • Supports the economic viability of the communities in which it operates. Besley Ch. 1

30. Multinational Corporations Five principal reasons companies go “international”: • Seek new markets • Seek raw materials • Seek new technology • Seek production efficiency • Avoid political and regulatory hurdles Besley Ch. 1

31. Multinational versus Domestic Managerial Finance Major differences of multinational companies from those operating entirely within a single country: • Multiple Currencies • Economic and legal ramifications • Language Differences • Cultural Differences • Governmental Role/Intervention • Political Risk Besley Ch. 1