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Financial Management

Overview

1
Finance
Finance is the study of how people and businesses
evaluate investments and raise capital to fund them.

Three Questions Addressed by the Study of Finance:


1. What long-term investments should the firm undertake?
(capital budgeting decisions)
2. How should the firm fund these investments? (capital
structure decisions)
3. How can the firm best manage its cash flows as they arise in
its day-to-day operations? (working capital management
decisions)
Finance
Finance is the study of how people and businesses
evaluate investments and raise capital to fund them.

Three Questions Addressed by the Study of Finance:


1. What long-term investments should the firm undertake?
(capital budgeting decisions)
2. How should the firm fund these investments? (capital
structure decisions)
3. How can the firm best manage its cash flows as they arise in
its day-to-day operations? (working capital management
decisions)
Finance
Knowledge of financial tools is critical to making good
decisions in both professional world and personal lives.
Finance is an integral part of corporate world
How will GMs strategic decision to invest $740 million to
produce the Chevy Volt require the expertise of different
disciplines within the business school such as marketing,
management, accounting, operations management, and finance?
Many personal decisions require financial knowledge (for
example: buying a house, planning for retirement, leasing a
car)
Business Organizational Forms

Business
Forms

Sole Partnerships
Corporations Hybrids
Proprietorships
Business Organizational Forms

Corporations: A business which is legally distinct from its


owners, who are called shareholders (SH).
Advantages:
Limited liability the shareholders can lose only the amount they
have invested in the companys shares (stock).
Disadvantages:
Double taxation the government taxes corporate earnings and the
dividends paid out of those earnings to the shareholders.
Corporations
One of the key features of a corporation is the separation of
ownership and management.
In proprietorships and partnerships, the owners are usually the
managers. In a corporation, SHs own the firm, but they do not usually
manage it.
So, how is a corporation managed?
The SHs elect a Board of Directors which appoints
management.
The Board is supposed to:
Represent the shareholders interests.
Ensure that management is running the firm in the shareholders
best interests.
Separation of ownership and management allows a corporation
more flexibility and permanence than other types of business
organization:
Managers may leave, or be replaced, but the firm continues.
A SH may buy/sell shares without affecting the operation of
business.
Separation of Ownership and
Managerial Control
Ownership Management

Founder-Owners

Family-Owned Firms

Modern Public Corporations


Shareholders Professional Managers
Corporations

Corporations

SHAREHOLDERS Elect
BOARD

CORPORATION
Manages
MANAGEMENT
Corporations

Sole Partnership Corporation


Proprietorship
Who owns the The manager Partners Shareholders
business?
Are managers No No Usually
and owners
separate?
What is the Unlimited Unlimited Limited
owners
liability?
Are the owner & No No Yes
business taxed
separately?
Finance Managers role

Maximization of
Shareholder Wealth!
Value creation occurs when
we maximize the share price
for current shareholders.
Corporations
Corporations

Sole Partnership Corporation


Proprietorship
Who owns the The manager Partners Shareholders
business?
Are managers No No Usually
and owners
separate?
What is the Unlimited Unlimited Limited
owners
liability?
Are the owner & No No Yes
business taxed
separately?
Business Organizational Forms

Capital Budgeting Decision


Successful financial managers purchase
assets which generate cash flows greater
than the cash needed to buy them.

$3 BILLION CASH FLOW OUT

Boeing
TO PURCHASE A
PRODUCTIVE ASSET WHICH 757 and
CREATES CASH FLOW IN 767 jets

$8 BILLION CASH FLOW IN By 1997


Business Organizational Forms
Capital Budgeting Decision
Unsuccessful financial managers purchase
assets which generate cash flows less
than the cash needed to buy them.

$2 Billion CASH FLOW OUT

Walt TO CONSTRUCT THE THEME


Disney PARK Disneyland
Paris

LESS THAN $1.8 BILLION ON CASH FLOW IN


The Role of the Financial Manager

(2) (1)

Firm's Financial Financial


(4a)
operations managers markets

(3) (4b)

(1) Cash raised from investors (financing decision)


(2) Cash invested in operating assets (capital budgeting decision)
(3) Cash generated by operations
(4a) Cash reinvested (retained earnings / internal financing)
(4b) Cash returned to investors (interest payments/dividends)
Business Organizational Forms
Financial managers are supposed to make financial
decisions that serve SHs interests.
Firms need assets to generate income to provide profits for
the shareholders.
These assets must be paid for.
The role of the financial manager is to determine:
What operating assets to invest in the capital budgeting decision.
How to pay for those assets the financing decision.
Business Organizational Forms
Financial managers are supposed to make financial
decisions that serve SHs interests.
Firms need assets to generate income to provide profits for
the shareholders.
These assets must be paid for.
The role of the financial manager is to determine:
What operating assets to invest in the capital budgeting decision.
How to pay for those assets the financing decision.
Business Organizational Forms
Financial managers are supposed to make financial
decisions that serve SHs interests.
Firms need assets to generate income to provide profits for
the shareholders.
These assets must be paid for.
The role of the financial manager is to determine:
What operating assets to invest in the capital budgeting decision.
How to pay for those assets the financing decision.
Business Organizational Forms
Financial managers are supposed to make financial
decisions that serve SHs interests.
Firms need assets to generate income to provide profits for
the shareholders.
These assets must be paid for.
The role of the financial manager is to determine:
What operating assets to invest in the capital budgeting decision.
How to pay for those assets the financing decision.
Key Terms
Corporate governance
Set of mechanisms used to manage the relationships
among stakeholders and to determine and control
the strategic direction and performance of
organizations
Governance Mechanisms
Agency Relationships

Key Terms
Agency relationship
Relationship which exists when one or more people
(principals) hire another person or people (agents) as
decision-making specialists to perform a service

Managerial opportunism
Seeking self-interest with guile (i.e., cunning or deceit)
An Agency Relationship
The Agency Problem

The agency problem occurs when the desires


or goals of the principal and agent conflict
and it is difficult or expensive for the principal
to verify whether the agent has behaved
inappropriately.
Problems with Separate
Ownership and Control
Principal and the agent having different
interests and goals
Shareholders lacking direct control in large
publicly traded corporations
Agent making decisions which result in actions
that conflict with interests of the principal
Product Diversification
as an Agency Problem
Interests of Top Executives
Increased compensation
Reduced employment risk
Interests of Shareholders
Increased value of firm
Reduced risk of firm failure
Use of Free Cash Flows
Free cash flows are resources remaining after
the firm has invested in all projects that have
positive net present values within its current
businesses.

The managerial inclination to overdiversify can be


acted upon when free cash flows are available.
Shareholders may prefer that free cash flows be
distributed to them as dividends, so they can
control how the cash is invested.
Manager and Shareholder Risk
and Diversification
Agency Costs and
Governance Mechanisms

Key Terms
Agency costs
The sum of incentive costs, monitoring costs,
enforcement costs, and individual financial losses
incurred by principals, because governance mechanisms
cannot guarantee total compliance by the agent
Regulatory Oversight of Corporate
Governance

2002 Sarbanes-Oxley (SOX) Act


2010 Dodd-Frank Wall Street
Reform and Consumer Protection
Act (Dodd-Frank)
Dodd-Frank Provisions
Creates a Financial Stability Oversight Council headed
by the Treasury Secretary
Establishes a new system for liquidation of certain
financial companies
Provides for a new framework to regulate derivatives
Establishes new corporate governance requirements
Regulates credit rating agencies and securitizations
Establishes a new consumer protection bureau,
providing for extensive consumer protection in financial
services
Ownership Concentration

Key Terms
Ownership concentration
Governance mechanism defined by both the number of
large-block shareholders and the total percentage of shares
they own

Large block shareholders


Shareholders owning a concentration of at least 5 percent of
a corporations issued shares
Effects of Ownership Concentration

Diffuse ownership produces weak monitoring of


managers decisions.
Ownership concentration is associated with lower levels
of firm product diversification.
High degrees of ownership concentration improve the
probability that managers strategic decisions will increase
shareholder value.
In general, ownership concentrations influence on
strategies and firm performance is positive.
Influence of
Institutional Owners

Key Terms
Institutional owners
Financial institutions such as stock mutual funds and
pension funds that control large-block shareholder
positions
Influence of
Institutional Owners
Becoming more active in efforts to influence the
corporations strategic decisions
Initially focused on CEO performance and
accountability
Now targeting ineffective boards of directors and
executive compensation policies
Growing efforts to expand shareholders decision
rights
Board of Directors

Key Terms
Board of directors
Group of shareholder-elected individuals whose primary
responsibility is to act in the owners interests by
formally monitoring and controlling the corporations
top-level executives
Board of Director Responsibilities

Direct the affairs of the organization


Punish and reward managers
Protect shareholders rights and interests
Protect owners from managerial
opportunism
Classifications of Boards of Directors
Members
Outsider Directors

Enhance managerial monitoring


Contribute to strategic direction
Provide valuable links to external
stakeholders
Promoted by regulatory agencies
Do not guarantee high performance
Problems with
Outsider-Dominated Boards
Limited access to daily operations and critical
information
May lack insights required to fully and perhaps
effectively evaluate manager decisions and
initiatives
Tendency to emphasize financial controls
Shifts risk to top-level managers
Can increase detrimental managerial actions
Trends Among Boards

Background diversity
Formal processes to evaluate board performance
Lead director role with strong agenda-setting and
oversight powers
Changes in compensation packages
Ownership stake requirements
Demand for greater accountability and improved
performance
Social networks with external stakeholders
Board Effectiveness

Become engaged in the firm, without


trying to micromanage it
Challenge the reasoning behind decisions,
but be supportive of decisions that are
made
Provide an independent perspective on
important decisions
Executive Compensation

Key Terms
Executive compensation
Governance mechanism that seeks to align the interests
of top managers and owners through salaries, bonuses,
and long-term incentive compensation, such as restricted
stock awards and stock options
Executive Compensation Issues
High visibility and controversy
surrounding CEO pay
Downward pressure from shareholders
and activists
Relationship to performance
Long-term incentive plans
Effective governance mechanism for firms
implementing international strategies
Executive Compensation for
International Strategies

Pay levels vary by regions of the world.


Owners of multinational corporations may be best served
with less uniformity across the firms foreign subsidiaries.
Multiple compensation plans increase the need for
monitoring and other related agency costs.
Complexity and potential dissatisfaction increase as
corporations acquire firms in other countries.
Long-Term Incentive Plans

Address potential agency problems


Viewed positively by the stock market
Reduce pressure for changes in the board
Reduce pressure for outside directors
Assumed to effectively link executive pay
with firm performance
The Effectiveness of
Executive Compensation
It is difficult to evaluate complex and nonroutine strategic
decisions made by top-level managers.
It is difficult to assess the long-term strategic effect of
current decisions which affect financial performance
outcomes over an extended period.
Multiple external factors affect a firms performance other
than top-level managerial decisions and behavior.
The Effectiveness of
Executive Compensation
Performance-based (incentive) compensation
plans are imperfect in their ability to monitor and
control managers.
Conflicting short-term and long-term objectives
have a complex effect on managerial decisions and
behaviors.
Excessive compensations correlate with weak
corporate governance.
Executive Compensation A
Question of Stock Issue Effectiveness

Manager wealth v. high stock prices


Earnings manipulations
Risk taking
Repricing
Backdating
Market for Corporate Control

Key Terms
Market for corporate control
An external governance mechanism which is composed of
individuals and firms that buy ownership positions in or
take over potentially undervalued corporations so they
can form new divisions in established diversified
companies or merge two previously separate firms
Market for Corporate Control

Addresses weak internal corporate


governance
Corrects suboptimal performance
relative to competitors
Disciplines ineffective or opportunistic
managers
Hostile Takeover
Defense Strategies
Market for Corporate Control

May not be entirely efficient


Lacks the precision of internal
governance mechanisms
Can be an effective constraint on
questionable manager motives
International
Corporate Governance
Similarities among governance structures in
industrialized nations are increasing.
Firms using an international strategy must
understand the dissimilarities in order to operate
effectively in different international markets.
Traditional governance structures in foreign
nations, like Germany and Japan, are being affected
by global competition.
Corporate Governance
in Germany
Concentration of ownership is strong.
Banks exercise significant power as a source of
financing for firms.
Two-tiered board structures, required for larger
employers, place responsibility for monitoring and
controlling managerial decisions and actions with
separate groups.
Power sharing includes representation from the
community as well as unions.
Corporate Governance
in Japan
Cultural concepts of obligation, family, and consensus
affect attitudes toward governance.
Close relationships between stakeholders and a company
are manifested in cross-shareholding and can negatively
impact efficiencies.
Banks play an important role in financing and monitoring
large public firms.
Despite the counter-cultural nature of corporate
takeovers, changes in corporate governance have
introduced this practice.
Global Corporate Governance

Relatively uniform governance structures are


evolving in developed countries.
These structures are moving closer to the
U.S. model of corporate governance.
Although implementation is slower, this
merging with U.S. practices is occurring even
in transitional economies.
Corporate Governance and Ethical
Behavior

In the U.S., shareholders (in the


capital market stakeholder group) are
Capital Market viewed as the most important
Stakeholders stakeholder group served by the board
of directors.
Hence, the focus of governance
mechanisms is on the control of
managerial decisions to ensure that
shareholders interests will be served.
Corporate Governance and
Ethical Behavior
It is important to serve the
interests of the firms multiple
stakeholder groups.

Product market stakeholders


(customers, suppliers, and host
Product Market communities) and organizational
Stakeholders stakeholders (managerial and non-
managerial employees) are also
Organizational important stakeholder groups.
Stakeholders
Corporate Governance and
Ethical Behavior
It is important to serve the
interests of the firms multiple
stakeholder groups.
Although the idea is subject to debate,
Capital Market some believe that ethically responsible
Stakeholders companies design and use governance
mechanisms that serve all
Product Market stakeholders interests.
Stakeholders Importance of maintaining ethical
behavior through governance
Organizational mechanisms is seen in the examples of
Stakeholders recent corporate scandals.
Corporate Governance and
Ethical Behavior
Design CEO pay structure with long-term focus
Actively set boundaries for ethical behavior
Actively define organizations values
Clearly communicate expectations to all stakeholders
Foster an ethical culture of accountability
Promote CEOs as positive role models
Monitor ethical behavior of top executives
Do not stifle manager flexibility and entrepreneurship

65
Ethical Question

Do managers have an ethical responsibility to


push aside their own values with regard to how
certain stakeholders are treated (i.e., special
interest groups) in order to maximize
shareholder returns?
Ethical Question

What are the ethical implications associated


with owners assuming that managers will act in
their own self-interest?
Ethical Question

What ethical issues surround executive


compensation? How can we determine
whether top executives are paid too much?
Ethical Question

Is it ethical for firms involved in the market


for corporate control to target companies
performing at levels exceeding the industry
average?
Why or why not?
Ethical Question

What ethical issues, if any, do top executives


face when asking their firm to provide them
with a golden parachute?
Ethical Question

How can governance mechanisms be designed


to ensure against managerial opportunism,
ineffectiveness, and unethical behaviors?

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