Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 23 Chapter 1 An Overview of Managerial Finance.

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 23

Chapter 1Chapter 1

An Overview

of Managerial

Finance


Learning Objectives1. Understand the general framework for financial decision making.

2. Describe the role of financial decision making in maximizing the value of

the firm.

3. Identify how to determine whether an investment should be made and how

to finance acceptable investments.

4. Explain what is meant by the risk/return trade-off and how risk and return

can affect management decisions.

5. Understand the role of financial institutions and markets and its effect on

financial decisions made by the firm.


Importance of Managerial Finance

Assets: Liabilities & Equity:

Current Assets Current Liabilities

Cash & M.S. Accounts payable

Accounts receivable Notes Payable

Inventory Total Current Liabilities

Total Current Assets Long-Term Liabilities

Fixed Assets: Total Liabilities

Gross f ixed assets Equity:

Less: Accumulated dep. Common Stock

Goodw ill Paid-in-capital

Other long-term assets Retained Earnings

Total Fixed Assets Total Equity

Total Assets Total Liabilities & Equity

CompanyBalance Sheet

As of December 31, 2004

Maximize wealth

notprofit!

Debts are paid

by cashflownot income!

InvestmentDecisions

utilizefunds

FinancingDecisions

require funds


The operation of a firm


Forms of Business Organization

• Advantages

– Easy formation with low organizational costs

– Affected by few government regulations

– Income included and taxed only on proprietor’s

personal tax return (i.e. only one)

Proprietorship



• Drawbacks

– Owner has unlimited liability (i.e. total wealth can be

taken to satisfy debts)

– Lacks continuity when proprietor dies

– Transferring of ownership is difficult

– Limited fund-raising power tends to inhibit growth

Proprietorship



• Advantages

– Fairly easy and inexpensive formation

– Affected by few government regulations

– Income included and taxed only on partner’s tax

return

Partnership



• Drawbacks

– Owners have unlimited liability and may have to

cover debts of other partners

– Partnership is dissolved when a partner dies

– Difficulty to liquidate or transfer partnership

– Difficulty of raising large amounts of capital

Partnership



• Advantages

– Long life of firm even if owners do not have a

relationship with the business

– Ownership (stock) is readily transferable

– Owners have limited liability which guarantees that

they cannot lose more than they invested

– Better access to financing

Corporation



• Drawbacks

– More expensive to organize than other business

forms and subject to greater government regulation

– Taxes are higher because of double taxation:

corporate income is taxed and also dividends paid

to owners are taxed

Corporation


Value maximized for corporations

• Limited Liability reduces the risk borne by investors

• A firm’s current value is related to its future growth

opportunities

•Corporate ownership can be transferred easier than the

ownership of either a proprietorship or a partnership

Why?


Role of Finance in a Business Organization


The Goals of the CorporationStockholder wealth maximization

• This should be the primary goal of a financial manager Incentives against are

to keep stockholder returns “at reasonable level” and work for other goals such

as:

– pursue goals of public service activities

– target employee benefits

– pursue higher executive salaries

• But…

– Competitive forces require financial managers to opt for stockholder wealth

maximization, to avoid losing their jobs


The Goals of the CorporationSocial Responsibility

• Firms should provide a safe environment, avoid air pollution and produce safe

products. Incentives against for firms to act in a socially responsible manner

are:

– Disadvantage in attracting funds due to extra costs incurred

– Inability to compete due to higher prices of products

– Constraints by capital market factors

• Therefore…

– Social Responsibility actions should be enforced on a mandatory rather than a

voluntary basis


The Goals of the CorporationStock Price Maximization and Social Welfare

• Shareholder Wealth Maximization is beneficial for the society:

– Stock price maximization requires efficient, low cost plants that produce

high-quality goods and services at a low cost

– Stock price maximization requires the development of products that

customers want and need, leading to new technology, new products

and new jobs

– Stock price maximization necessitates efficient service, adequate

stocks and well located business establishments


The Goals of the Corporation

Therefore primary goal is to Maximize Shareholder Wealth


Decisions affecting the firm’s value

nn

22

11

)k1(CF

)k1(CF

)k1(

CFvalueAsset

Value = Current (present) value of expected cash flows (CFs) based on the return

demanded by investors (k)

• How to finance (capital structure decision)

•What assets to purchase (capital budgeting decision)

•Pay dividends or re-invest earnings? (dividend policy

decision)


Present Value… explained• The value of any financial contract (i.e., stock) answers

the following questions:– 1. How much do I expect receipts to be (expected cash flow to

the investor (i.e., dividends))?– 2. When do I receive the payments (timing/opportunity cost)?– 3. What is the chance I do not receive what I expected (risk)?

• The Present Value (discounted) of cash flows received by an investor is used as the estimate of the value of a contract (i.e., shareholder wealth)

• The Present Value (discounted) of a single share is the shares market price

• Shareholders Wealth=Market Value of Equity=Number of shares * share price


Should Earnings Per Share Be Maximized?

Beware: Wealth is NOT profit!

Investment Year 1 Year 2 Year 3 Total

A 2,90 0,00 0,00 2,90

B 0,00 0,00 3,00 3,00

EPS (€)

Which Investment is Preferred?

Profit maximization fails to account for differences in the level of cash flows (as

opposed to profits), the timing of these cash flows, and the risk of these cash flows.


Make decisions about the cash flow Beware: Accounting is NOT an economic profit!

Sales Revenue (in €) 100.000 Cash Inflow s (in €) 100.000

Less: Costs (in €) 80.000 Less: Cash Outflow s(in €) 80.000

Net Profit (in €) 20.000 Net Cash Flow (in €) 20.000

Finance ViewCash Flow Statement

for the year ended 2004

Accounting ViewIncome Statement

for the year ended 2004

Cash flow is the actual cash generated by the firm. CF = Net Income + Depreciation or (CF = NI + DEP )


Agency Relationships

• Whenever a manager owns less than 100% of the

firm’s equity, a potential agency problem exists.

• In theory, managers would agree with shareholder

wealth maximization.

• However, managers are also concerned with their

personal wealth, job security, fringe benefits, and

lifestyle.

• This would cause managers to act in ways that do not

always benefit the firm’s shareholders.

Stockholders versus Managers – The problem



• Managerial compensation (in the form of performance

shares, executive stock options or restricted stock grants)

– But…. Recent studies have failed to find a strong relationship

between CEO compensation and share price.

• The threat of firing

•Shareholder intervention

•The threat of takeover

Stockholders versus Managers - Solutions



• Creditors consider the riskiness of the firm

• Stockholders should not act against creditors because

– Creditors protect themselves through restrictions in credit

agreements

– Creditors may request an interest rate much higher than

normal to compensate for the stockholder’s actions

•Result: Stockholders may find it difficult to borrow funds in

the future

Stockholders versus Creditors

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 23 Chapter 1 An Overview of Managerial Finance.

Documents

brigham slide

firm slide

funds slide

taxed corporation slide

financing corporation

growth proprietorship

business forms

financial decisions