Introduction to Finance

Book
Corporate Finance Foundations
Hirt, Block & Danielson
14 Edition
McGraw Hill
ISBN: 0077132910

Exam : 100%; 60 mins This course, its slides and all the materials
Prof. Roberto Anero and used in class is from the book –
“Corporate Finance Foundations” by
Prof Laxmi Remer Block, Hirt and Danielson
Chapter 1

The Goals and Functions of

Financial Management
Chapter Outline
• Introduction to Finance
• Forms of Organizations
• The Risk-Return Tradeoff
• Primary Goal of Financial Managers
• Role of Financial Managers
Relationship between Finance,
Economics and Accounting
• Economics provides a broad picture of the
economic environment for decision making in
many important areas
• Accounting, the language of finance, provides
financial data through:
– Income statements
– Balance sheets
– Statement of cash flows
• Finance links economic theory with the numbers
of accounting
Evolution of the Field of Finance
• At the turn of the century, finance emerged as
a field separate from economics
• By 1930s, financial practices revolved around
such topics as:
– Preservation of capital
– Maintenance of liquidity
– Reorganization of financially troubled corporations
– Bankruptcy process
Evolution of the Field of Finance
(cont’d)
• By mid-1950s, finance became more analytical
towards:
– Financial capital (money) being used to purchase
real capital (long-term plant and equipment)
– Cash and inventory management
– Capital structure theory
– Dividend policy
Modern Issues in Finance
• Focus has been on:
– Risk-return relationships
– Maximization of return for a given level of risk
– Portfolio management
– Capital structure theory
• New financial products with a focus on
hedging are being widely used
• Inflation – a key variable in financial decisions
Modern Issues in Finance (cont’d)
• The following are significant to financial
managers during decision making:
– Effects of inflation and disinflation on financial
forecasting
– Required rates of return for capital budgeting
decisions
– Cost of capital
Risk Management and the Financial
Crisis
• ‘Recent’ financial crisis due to:
– Unwarranted extension of credit
– Creation and sale of mortgage-backed securities
– Losses from credit defaults in excess of a bank’s
capital in many cases
• Creation of complicated and unregulated financial
products like Credit Default Swaps (CDS)
• Government action and bail-outs
• New regulations for financial institutions
The Impact of the Internet
• Internet and its acceptance has enabled
acceleration of e-commerce solutions for “old
economy” companies
• E-commerce solutions for existing companies
– B2C
– B2B
• Spurt in new business models and companies
– Amazon.com
– eBay
The Impact of the Internet (cont’d)
• For any financial manager, e-commerce
impacts financial management because it
affects the pattern and speed with which cash
flows through the firm
– B2C model:
• Products are bought with credit cards
• Credit card checks are performed
• Selling firms get the cash flow faster
– B2B model can help companies
• Lower the cost of managing inventory, accounts
receivable, and cash
Functions of Financial Management
 Financial management is concerned with
managing an entity’s money
 Functions:
– Allocate funds to current and fixed assets
– Obtain the best mix of financing alternatives
– Develop an appropriate dividend policy within the
context of the firm‘s objectives
Functions of the Financial Manager
Risk-Return Trade-Off
• Influences operational side (Capital vs. Labor /
Product A vs. Product B)
• Influences financial mix (Stock vs. Bonds vs.
Retained earnings)
Forms of Organization
• Different forms of organizations are:
– Sole Proprietorship
– Partnership
– Corporation
Sole Proprietorship
• Represents single-person ownership
• Advantages:
– Simplicity of decision-making
– Low organizational and operational costs
• Drawback - Unlimited liability to the owner
• Profits and losses are taxed as though they
belong to the individual owner
Partnership
• Similar to sole proprietorship except there are
two or more owners
– Articles of partnership specifies:
• The ownership interest
• The methods for distributing profits
• The means of withdrawing from the partnership
• Carries unlimited liability for the owners
Partnership (cont’d)
• Limited partnership
– One or more partners are designated general
partners and have unlimited liability for the debts
of the firm
– Other partners are designated limited partners and
are liable only for their initial contribution
• Not all financial institutions extend funds to a
limited partnership firm
Corporation
• Corporation
– Unique; it is a legal entity unto itself
− Formed through Articles of Incorporation, which
specify the rights and limitations of the entity
− Owned by shareholders who enjoy the privilege of
limited liability
− Has a continual life
• Key feature – Easy divisibility of ownership
interest by issuing shares of a stock
Corporation (cont’d)
• Disadvantage:
– The potential of double taxation of earnings
• Subchapter S corporation
– Income is taxed as direct income to stockholders
and is thus taxed only once as normal income
Corporate Governance
• Agency theory
– Examines the relationship between owners and
managers of the firm
• Institutional investors
– Have more to say about the way publicly owned
companies are managed
Sarbanes-Oxley Act
• Set up a five-member Public Company Accounting
Oversight Board (PCAOB) with responsibility for:
– Auditing standards within companies
– Controlling the quality of audits
– Setting rules and standards for the independence of the auditors
• Major focus is to make sure that publicly-traded
corporations accurately present their
– Assets
– Liabilities
– Equity and income on their financial statements
Goals of Financial Management
• Primary goal – Maximization of profit
– Drawbacks:
• A change in profit may also represent a change in risk
• Fails to consider the timing of the benefits
• Impossible task of accurately measuring the key
variable “profit”
• Broader goal – Maximizing Shareholder wealth
– Achieving the highest possible value for the firm
Management and Stockholder Wealth
• Only way to retain power in long run is by
becoming sensitive to shareholder concerns
• Sufficient stock option incentives to motivate
achievement of market value maximization
• Powerful institutional investors are making
management more responsive to shareholders
Valuation Approach
• The ultimate measure of performance – how the
earnings are valued by the investor
• In analyzing the firm, the investor will consider the:
– risk inherent in the firm’s operation
– time pattern over which the firm’s earnings increase or
decrease
– quality and reliability of reported earnings
• A finance manager must question the impact of each
decision on the firm’s overall valuation
• If a decision maintains or increases the firm’s overall
value, it is acceptable; otherwise, it should be rejected
Social Responsibility and
Ethical Behavior
• Adopting policies that:
– Maximize values in the market
– Attracts capital
– Provides employment
– Offers benefits to the society
• Certain cost-increasing activities may have to
be mandatory rather than voluntary initially, to
ensure burden falls equally over all business
firms
Social Responsibility and
Ethical Behavior (cont’d)
• Insider trading:
– Using information that is not available to the
public and making undue profit from trading
– Unethical and illegal practice
– Protected against by the Securities and Exchange
Commission (SEC)
• Ethical behavior creates invaluable reputation
The Role of Financial Markets
• Financial markets are indicators to
maximization of shareholder value and any
ethical or unethical behavior that may
influence the value of the company
• Participants in the financial market range from
individuals to various Public, Private, and
Government institutions
– Public financial markets
– Corporate financial markets
Structure and Functions
of the Financial Markets
• Distinct parts of financial markets:
– Domestic and international markets
– Corporate and government markets
– Money and capital markets
Structure and Functions
of the Financial Markets (cont’d)
• Money markets
− Deals with short-term securities that have a life of
one year or less
− Securities in these markets include:
− Commercial paper sold by corporations to finance their
daily operations
− Certificates of deposit with maturities of less than 12
months sold by banks
Structure and Functions
of the Financial Markets (cont’d)
• Capital markets
– Deals with securities that have a life of more than
one year
– Long-term markets
– Securities include:
• Common stock
• Preferred stock
• Corporate and government bonds
Allocation of Capital
• Primary market
– When a corporation uses the financial markets to raise new
funds, the sale of securities is made by way of a new issue
called an initial public offering or IPO
• Secondary market
– Securities are bought and sold amongst the investors
– Prices of securities keep changing continually
– Financial managers are given a feedback about their firms’
performance
Return Maximization
and Risk Minimization
• Investors can choose risk level that meets their
objective and maximizes return for that given
level of risk
• Companies that are rewarded with high-priced
securities can raise new funds in money
markets and capital markets at a lower cost
compared to competitors
• Firms pay a penalty for failing to perform
competitively
Restructuring
• Restructuring can result in:
– Changes in the capital structure (liabilities and
equity on the balance sheet)
– Selling of low-profit-margin divisions with the
proceeds from the sale reinvested in better
investment opportunities
– Removal of the current management team or large
reductions in the workforce
• Also includes mergers and acquisitions
Internationalization
of Financial Markets
• Allocation of capital and a search for lower-cost
sources of financing in global market
• The impact of international affairs and technology
has resulted in the need for future financial
managers to understand
− International capital flows
− Computerized electronic funds transfer systems
− Foreign currency hedging strategies
Technological Impact
on Capital Markets
• Cost reduction in trading securities
• Consolidation among major stock markets and
mergers of brokerage firms with domestic and
international partners
• Creation of electronic communication
networks (ECNs)
• Electronic markets like NASDAQ have gained
popularity as against traditional organized
exchanges such as NYSE