1) What longterm investments
FIN301: Chapter 1 1.1 Corporate Finance and the Financial Manager Corporate Finance: 1) What longterm investments should you take on? 2) Where will you get the longterm financing to pay for your investment? 3) How will you manage your everyday financial activities? Financial Manager: Makes business decisions for the shareholders and answers to the above three questions.
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The financial management function is usually associated with a top officer of the firm, such as a vice president of finance or some other chief financial officer (CFO). The CFO reports to the president, who is the chief operating officer (COO) in charge of daytoday operations. The COO reports to the chairman, who is usually chief executive officer (CEO). However, as businesses become more complex, there is a growing pattern among large companies to separate the roles of Chairman and CEO. The CEO has overall responsibility to the board. The vice president of finance coordinates the activities of the treasurer and the controller. The controller’s office handles cost and financial accounting, tax payments, and management information systems. The treasurer’s office is responsible for managing the firm’s cash, its financial planning, and its capital expenditures.
Financial Management Decisions a) Capital Budgeting: The process of planning and managing a firm’s investment in long term assets. In capital budgeting, the financial manager tries to identify investment opportunities that are worth more to the firm than they will cost to acquire. b) Capital Structure: The mix of debt and equity maintained by a firm. Two concerns are how much should the firm borrow and what are the least expensive sources of funds for the firm. c) Working Capital Management: Planning and managing the firm’s current assets & liabilities. Reference to shortterm assets & liabilities. Questions to be asked: • How much cash and inventory should we keep on hand? • Should we sell on credit? If so, what terms should we offer, and to whom should we extend them? • How do we obtain any needed shortterm financing? 1.2 Forms of Business: a) Sole Proprietorship: A business owned by a single individual. The owner maintains all profit and liabilities. Creditors can look beyond the company’s assets and use the owner’s personal assets to pay them since their income is classified as personal income. The lifespan of this type of business is generally short. b) Partnership: Owned by two or more coowners. Partners share the gains and losses, and all liabilities are on the owners. Limited partnership, one or more general partners has unlimited liability and runs the business for one or more limited partners who do not
actively participate in the business. Partnerships have the same disadvantages as proprietorship. c) Corporation: A business created as a distinct legal entity owned by one or more individuals or entities, it has many rights, duties and privileges on an actual person. Usually separate from management and ownership. Advantage: It can always raise money by selling stock to gain new investors. Disadvantage: It must pay double taxes. Corporate profit is taxed and taxed again when given out. 1.3 The Goal of Financial Management: The goal of financial management is to make money or add value for the owners.
1) 2) 3) 4) 5) 6) 7)
Possible Goals: Survive in business. Avoid financial distress and bankruptcy. Beat the competition. Maximize sales or market share. Minimize costs. Maximize profits. Maintain steady earnings growth. The goal of financial management is to maximize the current value per share of existing stock. A more general way of stating the goal is to maximize the market value of the owners’ equity. 1.4 The Agency Problem and Control of the Corporation: The relationship between shareholders and management is called an agency relationship. Agency problem: The possibility of conflicts of interest between the shareholders and management of a firm Management Goals: Agency costs refer to the costs of the conflict of interests between shareholders and management. These costs can be indirect or direct. An indirect agency cost is a lost opportunity. Direct agency costs come in two forms: The first is a corporate expenditure that benefits management but costs the shareholders. The second direct agency cost is an expense that arises from the need to monitor management actions. • Goals Management may have: Independence, Corporate SelfSufficiency, Power, and Corporate Size. • Managerial Compensation: Get to purchase stocks/bonds at current prices & ability to get promoted due to performance. Control of the firm ultimately rests with shareholders. They elect the board of directors, who, in turn, hire and fire management. Corporate governance: Rules for corporate organization and conduct.
Stakeholder: Anyone who potentially has a claim on a firm. Stakeholder is a shareholder, creditor, or other individual (or group) that potentially has a claim on the cash flows of the firm.
1.5 Financial Markets and the Corporation
Cash Flows to and from the Firm
1) 2) 3) 4) 5) 6) 7)
Firm selling shares of stock and borrowing money to raise cash: Cash flows to the firm from the financial market The firm invests the cash in current and fixed assets These assets generate some cash Some of which goes to pay corporate taxes After taxes are paid, some of this cash flow is reinvested in the firm The rest goes back to the financial markets as cash paid to creditors and shareholders
Financial markets can be classified as either money markets or capital markets. Money (Dealer) Markets: Financial markets where shortterm debt securities are bought and sold. Capital Markets: Financial markets where longterm debt and equity securities are bought and sold. Primary vs. Secondary Markets Primary markets refer to the original sale of securities by governments and corporations. The secondary markets are where these securities are bought and sold after the original sale. Solely corporations issue equities. Both governments and corporations issue debt securities. In a primary market transaction, the corporation is the seller, and the transaction raises money for the corporation. • Two types of primary market transactions: public offerings and private placements. A secondary market transaction involves one owner or creditor selling to another. Therefore, the secondary markets provide the means for transferring ownership of corporate securities. There are two kinds of secondary markets: auction markets and dealer markets. • Dealer markets in stocks and longterm debt are called overthecounter (OTC) markets. A third market involves trading exchangelisted securities in OTC markets. This fourth market trading involves institutiontoinstitution trading without using the services of brokers or dealers. The equity shares of most of the large firms in Canada trade in organized auction and dealer markets. Listing: Stocks that trade on an organized exchange are said to be listed on that exchange. To be listed, firms must meet certain minimum criteria concerning, for example, asset size and number of shareholders. These criteria differ for various exchanges. 1.6 Financial Institutions: Act as intermediaries between investors (funds suppliers) and firms raising funds. Financial institutions justify their existence by providing a variety of services that promote the efficient allocation of funds. These institutions also serve as intermediaries for households and individuals (save & borrow money). Chartered banks operate under federal regulation, accepting deposits from suppliers of funds and making commercial loans to midsized businesses, corporate loans to large companies, and personal loans and mortgages to individuals. Generate most of their income through the interest on the loans they hand out (indirect finance). Corporations can borrow other corporation’s money
using banker’s acceptance (direct finance). Trust companies also accept deposits and make loans. In addition, trust companies engage in fiduciary activities managing assets for estates, registered retirement savings plans and more. 1.7 Trends in Financial Markets and Financial Management Financial Engineering: Creation of new securities or financial processes. Successful financial engineering reduces and controls risk and minimizes taxes. Financial engineering creates a variety of debt and equity securities and reinforces the trend toward securitization of credit. Derivative Securities: Options, futures, and other securities whose value derives from the price of another, underlying, asset. Very useful in controlling risk, but they have also produced large losses when mishandled. Regulatory Dialectic: Pressures financial institutions and regulatory bodies exert on each other.
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• • •
The financial management function is usually associated with a top officer of the firm, such as a vice president of finance or some other chief financial officer (CFO). The CFO reports to the president, who is the chief operating officer (COO) in charge of daytoday operations. The COO reports to the chairman, who is usually chief executive officer (CEO). However, as businesses become more complex, there is a growing pattern among large companies to separate the roles of Chairman and CEO. The CEO has overall responsibility to the board. The vice president of finance coordinates the activities of the treasurer and the controller. The controller’s office handles cost and financial accounting, tax payments, and management information systems. The treasurer’s office is responsible for managing the firm’s cash, its financial planning, and its capital expenditures.
Financial Management Decisions a) Capital Budgeting: The process of planning and managing a firm’s investment in long term assets. In capital budgeting, the financial manager tries to identify investment opportunities that are worth more to the firm than they will cost to acquire. b) Capital Structure: The mix of debt and equity maintained by a firm. Two concerns are how much should the firm borrow and what are the least expensive sources of funds for the firm. c) Working Capital Management: Planning and managing the firm’s current assets & liabilities. Reference to shortterm assets & liabilities. Questions to be asked: • How much cash and inventory should we keep on hand? • Should we sell on credit? If so, what terms should we offer, and to whom should we extend them? • How do we obtain any needed shortterm financing? 1.2 Forms of Business: a) Sole Proprietorship: A business owned by a single individual. The owner maintains all profit and liabilities. Creditors can look beyond the company’s assets and use the owner’s personal assets to pay them since their income is classified as personal income. The lifespan of this type of business is generally short. b) Partnership: Owned by two or more coowners. Partners share the gains and losses, and all liabilities are on the owners. Limited partnership, one or more general partners has unlimited liability and runs the business for one or more limited partners who do not
actively participate in the business. Partnerships have the same disadvantages as proprietorship. c) Corporation: A business created as a distinct legal entity owned by one or more individuals or entities, it has many rights, duties and privileges on an actual person. Usually separate from management and ownership. Advantage: It can always raise money by selling stock to gain new investors. Disadvantage: It must pay double taxes. Corporate profit is taxed and taxed again when given out. 1.3 The Goal of Financial Management: The goal of financial management is to make money or add value for the owners.
1) 2) 3) 4) 5) 6) 7)
Possible Goals: Survive in business. Avoid financial distress and bankruptcy. Beat the competition. Maximize sales or market share. Minimize costs. Maximize profits. Maintain steady earnings growth. The goal of financial management is to maximize the current value per share of existing stock. A more general way of stating the goal is to maximize the market value of the owners’ equity. 1.4 The Agency Problem and Control of the Corporation: The relationship between shareholders and management is called an agency relationship. Agency problem: The possibility of conflicts of interest between the shareholders and management of a firm Management Goals: Agency costs refer to the costs of the conflict of interests between shareholders and management. These costs can be indirect or direct. An indirect agency cost is a lost opportunity. Direct agency costs come in two forms: The first is a corporate expenditure that benefits management but costs the shareholders. The second direct agency cost is an expense that arises from the need to monitor management actions. • Goals Management may have: Independence, Corporate SelfSufficiency, Power, and Corporate Size. • Managerial Compensation: Get to purchase stocks/bonds at current prices & ability to get promoted due to performance. Control of the firm ultimately rests with shareholders. They elect the board of directors, who, in turn, hire and fire management. Corporate governance: Rules for corporate organization and conduct.
Stakeholder: Anyone who potentially has a claim on a firm. Stakeholder is a shareholder, creditor, or other individual (or group) that potentially has a claim on the cash flows of the firm.
1.5 Financial Markets and the Corporation
Cash Flows to and from the Firm
1) 2) 3) 4) 5) 6) 7)
Firm selling shares of stock and borrowing money to raise cash: Cash flows to the firm from the financial market The firm invests the cash in current and fixed assets These assets generate some cash Some of which goes to pay corporate taxes After taxes are paid, some of this cash flow is reinvested in the firm The rest goes back to the financial markets as cash paid to creditors and shareholders
Financial markets can be classified as either money markets or capital markets. Money (Dealer) Markets: Financial markets where shortterm debt securities are bought and sold. Capital Markets: Financial markets where longterm debt and equity securities are bought and sold. Primary vs. Secondary Markets Primary markets refer to the original sale of securities by governments and corporations. The secondary markets are where these securities are bought and sold after the original sale. Solely corporations issue equities. Both governments and corporations issue debt securities. In a primary market transaction, the corporation is the seller, and the transaction raises money for the corporation. • Two types of primary market transactions: public offerings and private placements. A secondary market transaction involves one owner or creditor selling to another. Therefore, the secondary markets provide the means for transferring ownership of corporate securities. There are two kinds of secondary markets: auction markets and dealer markets. • Dealer markets in stocks and longterm debt are called overthecounter (OTC) markets. A third market involves trading exchangelisted securities in OTC markets. This fourth market trading involves institutiontoinstitution trading without using the services of brokers or dealers. The equity shares of most of the large firms in Canada trade in organized auction and dealer markets. Listing: Stocks that trade on an organized exchange are said to be listed on that exchange. To be listed, firms must meet certain minimum criteria concerning, for example, asset size and number of shareholders. These criteria differ for various exchanges. 1.6 Financial Institutions: Act as intermediaries between investors (funds suppliers) and firms raising funds. Financial institutions justify their existence by providing a variety of services that promote the efficient allocation of funds. These institutions also serve as intermediaries for households and individuals (save & borrow money). Chartered banks operate under federal regulation, accepting deposits from suppliers of funds and making commercial loans to midsized businesses, corporate loans to large companies, and personal loans and mortgages to individuals. Generate most of their income through the interest on the loans they hand out (indirect finance). Corporations can borrow other corporation’s money
using banker’s acceptance (direct finance). Trust companies also accept deposits and make loans. In addition, trust companies engage in fiduciary activities managing assets for estates, registered retirement savings plans and more. 1.7 Trends in Financial Markets and Financial Management Financial Engineering: Creation of new securities or financial processes. Successful financial engineering reduces and controls risk and minimizes taxes. Financial engineering creates a variety of debt and equity securities and reinforces the trend toward securitization of credit. Derivative Securities: Options, futures, and other securities whose value derives from the price of another, underlying, asset. Very useful in controlling risk, but they have also produced large losses when mishandled. Regulatory Dialectic: Pressures financial institutions and regulatory bodies exert on each other.
