CHAPTER 1 - B

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CHAPTER 1 - BH An Overview of Financial
ManagementPankaj Agrrawal, Ph.D.

• Career Opportunities
• Issues of the New Millennium
• Forms of Businesses
• Goals of the Corporation
• Agency Relationships

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Finance Concepts are Simple, the Behavioral
Aspects are not
Better than avg. drivers, pls. stand up.

• A today is better than a tomorrow
• (concept of TVM)
• Buy Low sell High (arbitrage fear and greed, I
  say fear of losing and missing are the only
  motivators)
• No free lunch (the world of risk and return,
  CAPM, APT)
• Prices do not instantaneously adjust to all new
  information (random price path ? irrationality)

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Lets take a 5-7 minute Initial Exam

• PA If you can get an asset worth 100 for 90,
  whats the instant profit you just made?

• If your initial investment declines by 50, what
  percentage increase will bring you back to even?
• If the average annual returns for the past two
  years has been 50 and 50, what is the return
  on your investment over those two years?
• If your investment has trebled in value, what is
  the associated percentage rise?

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Financial Management Issues of the New Millennium

• The effect of changing technology lower costs,
  efficient, barriers to entry lowered
• The globalization of business

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Relevance of Finance and Globalization

• If you are a Doctor / Engineer how does FM
  affect you?
• For self decisions day to day
• Good business organization

• If you are a Nebraska Homebuilder how does
  Globalization affect you? (discuss KO)
• Interest rates global- housing demand
• Local economy wheat demand - global

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Career Opportunities in Finance

• Money and capital markets
• Financial management
• Investments

• Financial Intermediaries Banking
• Corporate Finance Managing the financing of
  corporations
• Investment Management Portfolio Management

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Role of Finance in a Typical Business Organization
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Responsibility of the Financial Staff

• Maximize stock value by
• Forecasting and planning
• Investment and financing decisions
• Coordination and control
• Transactions in the financial markets
• Managing risk

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Percentage of Revenue and Net Income from
Overseas Operations for 10 Well-Known
Corporations, 2001
Company of Revenue from overseas of Net Income from overseas
Coca-Cola 60.8 35.9
Exxon Mobil 69.4 60.2
General Electric 32.6 25.2
General Motors 26.1 60.6
IBM 57.9 48.4
JP Morgan Chase Co. 35.5 51.7
McDonalds 63.1 61.7
Merck 18.3 58.1
3M 52.9 47.0
Sears, Roebuck 10.5 7.8
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Alternative Forms of Business Organization

• Sole proprietorship
• Partnership
• Corporation

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Sole proprietorships Partnerships

• Advantages
• Ease of formation
• Subject to few regulations
• No corporate income taxes
• Disadvantages
• Difficult to raise capital
• Unlimited liability
• Limited life

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Corporation

• Advantages
• Unlimited life
• Easy transfer of ownership
• Limited liability
• Ease of raising capital
• Disadvantages
• Double taxation (Delaware 300k companies)
• Cost of set-up and report filing

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Financial Goals of the Corporation

• The primary financial goal is shareholder wealth
  maximization, which translates to maximizing
  stock price.
• Do firms have any responsibilities to society
  (safety, pollution, antitrust- price gouging,fair
  hiring) at large? (DSEFX ETFKLD-show how to
  locate, SPX, VICEX 3yrs)
• Priced out of mkt
• Shunned by investors
• Social objectives have to be mandated role of
  Govt
• Is stock price maximization good or bad for
  society (efficient production, new technology,new
  jobs)?
• Should firms behave ethically?

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Is stock price maximization the same as profit
maximization (Rev-Cost)?

• No, despite a generally high correlation amongst
  stock price, EPS, and cash flow.
• Current stock price relies upon current earnings,
  as well as future earnings and cash flow.
• Some actions may cause an increase in earnings,
  yet cause the stock price to decrease risk
  impact (and vice versa).

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Agency relationships

• An agency relationship exists whenever a
  principal hires an agent to act on their behalf.
• Within a corporation, agency relationships exist
  between
• Shareholders and managers
• Shareholders and creditors

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Shareholders versus Managers

• Managers are naturally inclined to act in their
  own best interests (ICC).
• But the following factors affect managerial
  behavior
• Managerial compensation plans
• Direct intervention by shareholders (free rider
  problem Satellite Dish example)
• The threat of firing
• The threat of takeover (poison pills, greenmail)

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Shareholders versus Creditors

• Shareholders (through managers) could take
  actions to maximize stock price that are
  detrimental to creditors.
• In the long run, such actions will raise the cost
  of debt and ultimately lower stock price.

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Factors that affect stock price

• Projected cash flows to shareholders
• Timing of the cash flow stream
• Riskiness of the cash flows

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Basic Valuation Model

• AP(1r)n gt 110 100(110) 1 yr
• For 2 years CF is 10/(1.1)(10 of
  100)/(1.11.1)100/(1.21) (1110100)/1.21
  gt100
• Or 9.0910/1.21100/1.21 9.098.2682.64 gt99.99
  (A one yr from now is more valuable than two
  yrs from now)
• To estimate an assets value, one estimates the
  cash flow for each period t (CFt), the life of
  the asset (n), and the appropriate discount rate
  (k)
• Throughout the course, we discuss how to estimate
  the inputs and how financial management is used
  to improve them and thus maximize a firms value.

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Factors that Affect the Level and Riskiness of
Cash Flows

• Decisions made by financial managers
• Investment decisions
• Financing decisions (the relative use of debt
  financing)
• Dividend policy decisions
• The external environment

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Austrian Economic Cycle
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HW

• Questions Ch 1 1-1, 1-5, 1-6, 1-7, 1-8 and ST -1
  (solutions at end of book, in Appx B)?----?
• Read Ch 4, self review ST questions page 159