© 2005 McGraw-Hill Ryerson Limited© 2003 The McGraw-Hill Companies, Inc. All rights reserved.

© 2003 The McGraw-Hill Companies, Inc. All rights reserved.

The University of Lethbridge - Faculty of Management

Management 3040 – Finance

Terry D. Harbottle

© 2005 McGraw-Hill Ryerson Limited

Chapter 1 - Key Concepts and Skills

• Know the basic types of financial management decisions and the role of the financial manager

• Know the financial implications of the different forms of business organization

• Know the goal of financial management

• Understand the conflicts of interest that can arise between owners and managers

• Understand the various types of financial markets and financial institutions

• Understand current trends in Canadian financial markets

1.1

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Chapter Outline

• Corporate Finance and the Financial Manager• Forms of Business Organization• The Goal of Financial Management• The Agency Problem and Control of the

Corporation• Financial Markets and the Corporation• Financial Institutions• Trends in Financial Markets and Financial

Management

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Corporate Finance

• Some important questions that are answered using finance– What long-term investments should the firm take

on?– Where will we get the long-term financing to pay

for the investment?– How will we manage the everyday financial

activities of the firm?– How can we manage financial and market risk?

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Financial Manager

• Financial managers try to answer some or all of these questions

• The top financial manager within a firm is usually the Chief Financial Officer (CFO)– Treasurer – oversees cash management, capital

expenditures and financial planning– Controller – oversees taxes, cost accounting,

financial accounting and data processing

1.4

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A Simplified Organizational Chart

Chairman of the Board andChief Executive Officer (CEO)

Board of Directors

President and ChiefOperations Officer (COO)

Vice PresidentMarketing

Vice PresidentFinance (CFO)

Vice PresidentProduction

Treasurer Controller

Cash Manager Credit Manager Tax ManagerCost AccountingManager

CapitalExpenditures

FinancialPlanning

FinancialAccountingManager

Data ProcessingManager

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Financial Management Decisions

• Capital budgeting– What long-term investments or projects should the

business take on?

• Capital structure– How should we pay for our assets?– Should we use debt or equity?

• Working capital management– How do we manage the day-to-day finances of the

firm?

• Risk Management– Use of derivative securities

1.5

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Forms of Business Organization

• Three major forms in Canada– Sole proprietorship– Partnership

• General

• Limited

– Corporation• In other countries, corporations are also called joint stock

companies, public limited companies and limited liability companies

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Sole Proprietorship

• Advantages– Easiest to start

– Least regulated

– Single owner keeps all the profits

– Taxed once as personal income

• Disadvantages– Unlimited liability

– Limited to life of owner

– Equity capital limited to owner’s personal wealth

– Difficult to sell ownership interest

1.7

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Partnership

• Advantages– Two or more owners

– More capital available

– Relatively easy to start

– Income taxed once as personal income

• Disadvantages– Unlimited liability

• General partnership

• Limited partnership

– Partnership dissolves when one partner dies or wishes to sell

– Difficult to transfer ownership

1.8

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Corporations

A corporation is a legal entity separate and distinct from its owners • has many of the same rights, duties and privileges of an actual

person:– borrow money– can own property– can enter into contracts

• shareholders and management are usually separate in most larger corporations – the shareholders elect the board of directors – the board then selects the senior managers who in theory are

charged with running the affairs in the interests of the shareholders

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Corporation

• Advantages– Limited liability

– Unlimited life

– Separation of ownership and management

– Transfer of ownership is easy

– Easier to raise capital

• Disadvantages– Separation of ownership

and management

– Double taxation (income is taxed at the corporate rate and then dividends are taxed at the personal rate)

1.9

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Goal Of Financial Management

• What should be the goal of a corporation?– Maximize profit?– Minimize costs?– Maximize market share?– Maximize the current value of the company’s

stock?

• Does this mean we should do anything and everything to maximize owner wealth or ‘shareholder value’?

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Primary Goal of Financial Management

• Three equivalent goals of financial management:– Maximize shareholder wealth or ‘shareholder

value’– Maximize share price– Maximize firm value

….goal is to increase ‘shareholder value’

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Corporation Finance

The study of the relationship between business decisions and shareholder value

The focus of this class then is the identification of financial/business decisions and arrangements that contribute to shareholder value (contribute favourably to value of the stock)

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The Agency Problem

• Agency relationship– Principal hires an agent to represent their interests– Stockholders (principals) hire managers (agents) to

run the company

• Agency problem– Conflicts of interest can exist between the principal

and the agent

• Agency costs– Direct agency costs– Indirect agency costs

1.13

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The Agency Problem

Agency Relationships and Management Goals– potential for conflict - is their too much emphasis on

corporate survival, job security and (more recently) with management wealth creation?

– Do managers Act in the Shareholders’ interests? They are influenced by:

• how they are compensated - does their compensation encourage them to make decisions that will enhance shareholder value

• how easily are they replaced if they do not pursue shareholder goals - control here is with the board of directors

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Agency Costs

Agency Costs - defined as the costs associated with the conflict

of interests :

Direct agency costs

Indirect agency costs

• Impact of Agency Costs on Shareholder Wealth or Value

– direct - expenditures benefiting Management e.g. the unneeded corporate jet or

– direct - monitoring costs e.g. outside auditors

– indirect - lost opportunity where Management is not acting in the best interests of its shareholders e.g. costly acquisitions driven more by desire for power and prestige

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Managing Managers

• Managerial compensation– Incentives can be used to align management and

stockholder interests– The incentives need to be structured carefully to

make sure that they achieve their goal

• Corporate control– The threat of a takeover may result in better

management

• Conflicts with other stakeholders (see table 1.2)

1.14

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What is the role of financial markets in corporate finance?

• Cash flows to and from the firm• Money vs. capital markets• Primary vs. secondary markets

• How do financial markets benefit society?

1.16

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Cash Flows to and from the Firm1.17

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Financial Institutions

• Financial institutions act as intermediaries between suppliers and users of funds

• Institutions earn income on services provided:– Indirect finance – Earn interest on the spread

between loans and deposits– Direct finance – Service fees (i.e. bankers

acceptance and stamping fees)

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Financial Markets

Financial Markets - brings buyers and sellers of debt and equity securities together

• How do financial markets differ?– Type of securities traded/how trading is conducted and who

the buyers and sellers are

• Money markets and capital markets– money market - short term debt securities

– capital market - long term debt and equity

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Financial Markets Continued

• Primary vs. secondary markets

– Primary Market- where the original sale of issue of a

security by a government or corporation occurs

• public offering - underwritten by an investment dealer

and registered with provincial securities commissions

• private placement - debt and equity sold directly to a

buyer - typically life insurance companies and , pension

funds

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Financial Markets Continued

– Secondary Market - trading of securities

subsequent to the initial sale - enables the transfer

of ownership

• auction market - TSE

• dealer market - ‘over the counter (OTC) ‘

• How do financial markets benefit society?

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Financial Markets and Society

• what is the benefit to society?– Channel savings into investment– produce and transmit information on returns and

risk– provide a media and a payments system– enable the shifting of the timing of consumption

over a life cycle– enable the management of risk– enable the diversification of portfolios

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Trends in Financial Markets and Management

• Financial Engineering• Derivative Securities• Advances in Technology – i.e. E-business• Deregulation• Corporate Governance Reform

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Quick Quiz

• What are the three types of financial management decisions and what questions are they designed to answer?

• What are the three major forms of business organization?

• What is the goal of financial management?• What are agency problems and why do they

exist within a corporation?• What is the difference between a primary

market and a secondary market?

1.20

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Summary 1.9

• You should know:– The advantages and disadvantages between a sole

proprietorship, partnership and corporation– The primary goal of the firm– What an agency relationship and cost are– The role of financial markets

1.21