The Firm and The Financial Manager

1
Chapter 1

The Firm and The Financial Manager (??????)
2
Topics Covered

• Organizing a Business
• The Role of The Financial Manager
• Financial Markets
• Who Is The Financial Manager?
• Corporate Goals Incentives (understand the
  conflicts of interest that can arise between
  owners and managers)
• Value Maximization (goals of financial management)

3
Organizing a Business

• Types of Business Organizations
• Sole Proprietorships (??)
• Partnerships (??) Microsoft, Apple Computer,
  Merrill Lynch, Goldman Sachs, Morgan Stanley
• Corporations (?? ??)
• Hybrids (???)
• Limited Partnerships (????)
• Limited Liability Partnerships LLP (????)
• Limited Liability Company LLC (??????)
• Professional Corporation PC (????????)

4
Corporate Structure
Sole Proprietorships
Partnerships
Corporations
5
Organizing a Business
6
Sole Proprietorship

• Advantages
• Easiest to start
• Least regulated
• Single owner keeps all the profits
• Taxed once as personal income

• Disadvantages
• Limited to life of owner
• Equity capital limited to owners personal wealth
• Unlimited liability
• Difficult to sell ownership interest

7
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

8
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 taxed at the corporate
  rate and then dividends taxed at personal rate)

9
A Comparison of Partnershipand Corporations
10
The Role of The Financial Manager
Financial
Firm's
Financial
Markets (financial assets)
managers
operations (real assets)
11
The Three Major Decisions in Corporate Finance

• The Allocation (Investment) Decision
• Where do you invest the scarce resources of your
  business?
• What makes for a good investment?
• The Financing Decision
• Where do you raise the funds for these
  investments?
• Generically, what mix of owners money (equity)
  or borrowed money (debt) do you use?
• The Dividend Decision
• How much of a firms funds should be reinvested
  in the business and how much should be returned
  to the owners?

12
The Balance-Sheet Model of the Firm
13
The Balance-Sheet Model of the Firm
The Capital Budgeting Decision
Current Liabilities
Current Assets
Long-Term Debt
What long-term investments should the firm engage
in?
Fixed Assets 1 Tangible 2 Intangible
Shareholders Equity
14
The Balance-Sheet Model of the Firm
The Capital Structure Decision
Current Liabilities
Current Assets
Long-Term Debt
How can the firm raise the money for the required
investments?
Fixed Assets 1 Tangible 2 Intangible
Shareholders Equity
15
Capital Structure Decision
? The value of the firm can be thought of as a
pie.
50 Debt
? The goal of the manager is to increase the size
of the pie.
50 Equity
? The Capital Structure decision can be viewed
as how best to slice up a the pie.
? If how you slice the pie affects the size of
the pie, then the capital structure decision
matters.
16
The Balance-Sheet Model of the Firm
The Net Working Capital Investment Decision
Current Liabilities
Current Assets
Net Working Capital
Long-Term Debt

• How much short-term cash flow does a company need
  to pay its bills?

Fixed Assets 1 Tangible 2 Intangible
Shareholders Equity
17
First and Last Principles of Corporate Finance

• Invest in projects that yield a return greater
  than the minimum acceptable hurdle rate.
• The hurdle rate should be higher for riskier
  projects and reflect the financing mix used -
  owners funds (equity) or borrowed money (debt).
• Returns on projects should be measured based on
  cash flows generated and the timing of these cash
  flows they should also consider both positive
  and negative side effects of these projects.
• Choose a financing mix that minimizes the hurdle
  rate and matches the assets being financed.
• If there are not enough investments that earn the
  hurdle rate, return the cash to stockholders.
• The form of returns - dividends and stock
  buybacks - will depend upon the stockholders
  characteristics.
• Objective Maximize the Value of the Firm

18
The Role of The Financial Manager

• Investment Decisions (????)
• Capital Budgeting (??????) what long-term
  investments or projects should the business take
  on?
• Buy real assets that are worth more than they
  cost (???? gt ????)
• Real Assets (?????) assets used to produce goods
  and services, e.g., factories, machinery,
  trademarks, patents, know-how
• Financial Assets (?????) claims to the income
  generated by real assets, also called securities

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The Role of The Financial Manager

• Capital Budgeting

Tangible Assets Euro Disney _at_ 2 billion
Nontangible Assets Gillettes Mach3 Razor _at_ 300
million
20
The Role of The Financial Manager

• Financing Decisions
• Source of Funds Capital Markets (????)
• Capital Structure (??????, how much debt equity
  to issue?)
• Money Markets (????)
• Euros (??) and Eurodollar market (????)
• Functions of financial markets (1) Direct the
  fund,
• (2) Payment services, (3) Smoothing consumption
• (borrowing and lending), (4) Pooling risk

21
Financial Markets
Money
Primary Markets
OTC Markets
Secondary Markets
22
Financial Markets
Issue Debt
Company
Investors
Cash
23
Financial Markets
Company
Intermediary
Investor
24
Financial Markets
Company
2.5 mil
Loan
Banks
Intermediary
Deposits
Cash
Depositors
Investor
25
Financial Markets
Company
250 mil
Loan
Insurance Company
Intermediary
Sell policies Issue Stock
Cash
Policyholders
Investor
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Hypothetical Organization Chart
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Goals of The Corporation

• Shareholders desire wealth maximization
  (??????????????vs.???????)
• Do managers maximize shareholder wealth?
• Agency relationship
• Principal hires an agent to represent their
  interest
• Stockholders (principals) hire managers (agents)
  to run the company
• Mangers have many constituencies stakeholders
  (?????)
• Agency Problems (?????) represents the conflict
  of interest between management and owners

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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 companys
  stock?
• Does this mean we should do anything and
  everything to maximize owner wealth?

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Ownership vs. Management

• Difference in Information
• Stock prices and returns
• Issues of shares and other securities
• Dividends
• Financing
• A complete contract is impossible
• How to align interest?

• Different Objectives
• Managers vs. stockholders
• Top mgmt vs. operating mgmt
• Stockholders vs. banks and lenders
• Employees vs. operating mgmt
• Government vs. corp.

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The Classical Objective Function
STOCKHOLDERS
Hire fire managers - Board - Annual Meeting
Maximize stockholder wealth
Lend Money
No Social Costs
Managers
BONDHOLDERS
SOCIETY
Protect bondholder Interests
Costs can be traced to firm
Reveal information honestly and on time
Markets are efficient and assess effect on value
Ideal World
FINANCIAL MARKETS
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What Can Go Wrong?
STOCKHOLDERS
Managers put their interests above stockholders
Have little control over managers
Significant Social Costs
Lend Money
Managers
BONDHOLDERS
SOCIETY
Some costs cannot be traced to firm
Bondholders can get ripped off
Delay bad news or provide misleading information
Markets make mistakes and can over react
In Reality
FINANCIAL MARKETS
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The Counter Reaction
STOCKHOLDERS
Managers of poorly run firms are put on notice.
1. More activist investors 2. Hostile takeovers
Protect themselves
Corporate Good Citizen Constraints
Managers
BONDHOLDERS
SOCIETY
1. Covenants 2. New Types
1. More laws 2. Investor/Customer Backlash
Firms are punished for misleading markets
Investors and analysts become more skeptical
Cure In Reality
FINANCIAL MARKETS
33
Goals of The Corporation

• Agency Problem Solutions (??????????)
• 1 - Compensation plans (????)
• 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
• 2 - Board of Directors (?????)
• 3 - Takeovers (????) and Corporate Control
• The threat of a takeover may result in better
  management
• 4 - Specialist Monitoring and stakeholders
  (??????)
• 5 - Auditors (????????)

34
Corporate Securities as Contingent Claims on
Total Firm Value

• The basic feature of a debt is that it is a
  promise by the borrowing firm to repay a fixed
  dollar amount of by a certain date.
• The shareholders claim on firm value is the
  residual amount that remains after the
  debt-holders are paid.
• If the value of the firm is less than the amount
  promised to the debt-holders, the shareholders
  get nothing.

35
Debt and Equity as Contingent Claims
If the value of the firm is more than F, debt
holders get a maximum of F.
If the value of the firm is less than F, share
holders get nothing.
F
If the value of the firm is more than F, share
holders get everything above F.
Debt holders are promised F.
If the value of the firm is less than F, they
get the whatever the firm if worth.
Algebraically, the bondholders claim is
MinF,X B sell put options to S
Algebraically, the shareholders claim is
Max0,X F B sell call options to S
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Combined Payoffs to Debt and Equity
If the value of the firm is less than F, the
shareholders claim is Max0,X F 0 and
the debt holders claim is MinF,X X. The
sum of these is X
F
If the value of the firm is more than F, the
shareholders claim is Max0,X F X F
and the debt holders claim is MinF,X F.
The sum of these is X
Debt holders are promised F.