overview of financial management - lakehead...

Overview of Financial Management

Lakehead University

September 2004

What is Finance?

Businesses (and individuals) regularly need answers to the

following questions:

• What long term investments to undertake?

• How to finance these projects? Debt or Equity?

• How to value debt? How to value equity?

• How to manage everyday financial activities?

A course in corporate finance provides the tools necessary to

answer these questions.

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Major Areas in Finance

• Financial Markets

• Financial Services

• Managerial Finance

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Basic Forms of Business Organization

There are three different legal forms of business organization:

• Sole proprietorship

• Partnership

• Corporation

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Sole Proprietorship

Advantages:

Simple to form

Owner keeps all the profits

Disadvantages:

Owner has unlimited liability with respect to debt

Business income is taxed at the owner’s personal income

Life of business limited

Owner cannot raise more than her own wealth as equity

Ownership difficult to transfer

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Partnership

Advantages and disadvantages are basically the same as sole

proprietorship, except for partners’ liability.

General partnershave unlimited liability,

limited partnershave limited liability.

In ageneral partnership, all partners have unlimited liability.

In a limited partnership, one or more general partners run the

business for one or more limited partners.

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Corporation

In terms of size, this is the most important form of organization

in Canada.

A corporation is a legal entity distinct from its owners.

A corporation has rights and responsibilities similar to that of a

person: It can borrow money, it can sue and can be sued, etc..

A corporation can be involved in partnerships, and can be the

owner of another corporation.

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Corporation

Advantages:

Owners have limited liability for the firm’s debt

Ownership is easy to transfer

Life of the firm is basically inifinite

Easy to raise cash

Disadvantages:

Complex to form

Agency problems: shareholders-bondholders,

shareholders-managers

Double taxation of dividends

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The Managerial Finance Function

Organization of the Finance Function

The size and importance of the managerial finance function

depends on the size of the company.

In small firms, the financial decisions are usually made by the

accounting department.

As a firm grows, a separate department is created for the finance

function.

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Board of Directors (elected by shareholders)

Chairman of the Board and CEO

President and COO

V-P Marketing V-P Finance (CFO) V-P Production

Treasurer

Cash Credit

Capital Expenditures

Financial Planning

Controller

Taxes Accounting

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Financial Decisions

• Capital Budgeting

What type of investment opportunities to consider?

• Capital Structure

How much to borrow? What should the mixture of debt and

equity be?

• Working Capital Management

How to manage short-term assets and liabilities?

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Relationship to Economics

Financial managers must be aware of economic principles when

making decisions.

One of these principles ismarginal analysis: Actions should be

taken only whenadded benefitsexceedadded costs.

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Example of Marginal Analysis

A firm is considering replacing its old computers with new ones.

The present value of all benefits from the old computers is

evaluated at $35,000.

The present value of all benefits from the new computers is

evaluated at $100,000.

Old computers can be sold for $20,000.

New computers cost $75,000.

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Example of Marginal Analysis (continued)

Added benefits from replacing the old computers:

$100,000− $35,000 = $65,000.

Added costs from replacing the old computers:

$75,000− $20,000 = $55,000.

Net benefit is then

$65,000− $55,000 = $10,000.

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Emphasis on Cash Flows

Under the generally accepted accounting principles (GAAP),

sales and expenses are recognized on an accrual basis, which

means that revenues and cost of goods sold are recognized at the

time of the sale, not when cash is paid.

The financial manager is concerned about cash flows, i.e. cash

that is actually received and paid by the firm.

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Cash Flow Example

XYZ, Inc., has sold $1M worth of goods in 2000, its first year of

operation.

$100,000 of the 2000 sales have yet to be paid by customers.

In January 2000, XYZ has purchased $5M worth of equipment

expected to depreciate to zero in a straight line over 10 years (the

equipement loses $500,000 of its value each year).

Costs of goods sold were $300,000 during the year, from which

$50,000 have yet to be paid by XYZ.

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Cash Flow Example (continued)

Accounting income in 2000:

$1,000,000︸︷︷︸Sales in 2000

− $300,000︸︷︷︸COGS in 2000

− $500,000︸︷︷︸Depreciation in 2000

= $200,000.

Cash flow in 2000:

$900,000︸︷︷︸Cash from Sales

− $250,000︸︷︷︸Cash for COGS

− $5,000,000︸︷︷︸Investments in 2000

= −$3,850,000.

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Key Activities of the Financial Manager

• Capital Budgeting

What type of investment opportunities to consider?

• Capital Structure

How much to borrow? What should the mixture of debt and

equity be?

• Working Capital Management

How to manage short-term assets and liabilities?

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Goal of the Financial Manager

• Survive in business? Avoid financial distress?

• Maximize sales?

• Maximize profits?

• Maintain growth in earnings?

• Maximize the stock price?

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The right goal needs to take cash flows, the timing of these cash

flows and risk into account.

Maximizing shareholder wealth takes all these into account.

What about other stakeholders (employees, customers, creditors,

etc.)?

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The Role of Ethics

• Environment-friendly operations

• Charity donations

• Timely disclosure of material information

• Transparent accounting practices

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Benefits from an Ethics Program

• Reduce potential litigation and judgement costs

• Maintain a positive corporate image

• Build shareholder confidence

• Gain the loyalty, commitment and respect of the firm’s

stakeholders

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The Agency Issue

Agency relationship: A principal (owners) hires an agent

(managers) to generate revenues. If the principal cannot perfectly

monitor the agent’s actions and the latter has goals that differ

from those of the owner, then the owner’s objectives may not be

attained.

Managers’ potential goals: Keep their jobs (take insufficient

risks), perquisites, etc.

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The Agency Issue

Managers’ goals can be aligned with those of shareholders using

the right incentives.

• Managerial compensation linked to firm’s success.

• Control of the firm in shareholders’ hands: Takeover threats,

independence of directors.

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Another Agency Problem

Bondholders and shareholders may have conflicting interests.

Due to shareholders’ limited liability, the latter may want to take

risks that reduce the market value of debt.

On the other hand, shareholders may prefer a dividend to the

undertaking of a profitable project, as some of the project’s

return will be distributed to bondholders, whereas dividends all

go to shareholders.

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Financial Markets and the Corporation

Financial markets bring buyers and sellers of capital together.

Firms obtain cash from individuals by issuing debt or equity.

Individuals obtain cash from firms through dividends, capital

gains and interest.

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Firms investin assets

Current assetsFixed assets

Financialmarkets

Short-term debtLong-term debtEquity shares

Firms issue securities�

-Dividends, interest payments

�Cash reinvested

Taxes and other

?

GovernmentOther stakeholders

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