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Chapter One An overview of Managerial Finance

What is Finance Finance is the application of economic

principles Finance is the art and science of managing

money Finance is concerned with the process of

money transfer between the various economic units ( individuals, households, businesses and governments).

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Corporation:

A legal entity created by a state Separate and distinct from it’s owners and

managers. Management is separated from owners Incorporation : is the process by which a

company receives a state charter allowing it to operate as a corporation.

Articles of incorporation: document filed with a state or government by the founders of a corporation.

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Advantages of Corporations

Limited liability Large capital could be obtained Ownership easily transferred Unlimited life. Can easily raise money in the financial

market.

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Disadvantages of Corporations Double taxation Subject to greater government regulation Expensive and complex to form. Setting up a corporation could be time

consuming.

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Finance in the organizational structure of the firm

Board of Directors

PresidentCEO

Vice PresidentVice President

FinanceCFO

Vice President Vice president

Treasurer Controller

Tax Dept

Cost Acc.

Finan. Acc.

Credit Manager

Inventory Manager

Director of capital budgeting

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Responsibilities of Financial Management Main responsibility is to make decisions

concerning the acquisition and use of funds for the greatest benefit of the firm

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Financial Managers Activities Forecasting and planning Making investment decisions Making financial decisions Coordination and control Dealing with the financial markets

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Goals of Corporation The Main goal of corporations is maximizing

shareholders wealth ( maximizing the value of the firm) by maximizing the price of the firm’s stock.

Managerial Incentives to Maximize Shareholder Wealth:Besides wealth and dividend maximization objectives, managers may pursue other objectives such as higher executive salaries and employee benefits. However, competitive forces generally require managers to make attempts to maximize shareholders wealth. If they don't, then managers risk loosing their jobs.

Social responsibility; May include welfare of the employees, customer satisfaction and the community at large.

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Goals of Corporation…………cont. Ethical Responsibility ;providing safe working

environment, avoid polluting the air and to produce safe products.

Socially responsible actions have costs and firms which act in a a socially responsible manner ,while others do not ,will be at a disadvantage in attracting funds.

Cost –increasing actions associated with social responsibility will have to be put on a mandatory rather than a voluntary basis to ensure that the burden falls uniformly on all businesses and to maintain fair competition.

Stock price maximization and social welfare: Most actions that help a firm increase the price of its stock also are beneficial to society at large.

Most executives believe that there is a positive correlation between ethics and long run profitability of the firm !!!!

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Managerial Actions to Maximize Shareholder Wealth

Management’s decisions can significantly affect the firm’s value.

Managers can increase the value of a firm by making decision that :

- Increase the level of expected future cash flows (CFs)

- Generate the expected (CFs) sooner (The timing of CFs)

- Increase the certainty of the expected CFs. (riskiness of CFs)

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Managerial Actions to………contDecisions about expected CFs include : Capital structure decisions : how much and what

type of debt and equity should be used to finance the firm?

Capital budgeting decisions : what type of assets should be purchased to help generate future CFs?

Dividend Policy decisions: How much of current earnings to pay out as dividends rather than to retain for reinvestment in the firm

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Managerial actions……………..cont Given external factors and constraints such as ;

the legal constraints, level of economic activity, tax laws and stock market conditions, management makes a set of long-run strategic policy decisions that chart a future course for the firm.

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Should Earnings Per Share (EPS) be maximized?

Financial managers who attempt to maximize earnings might not maximize value.!!

Earnings maximization is a short-sighted goal as it does not consider the timing of earnings nor the firm’s future risk position.

N.B (EPS= NI divided by the numbers of shares outstanding)

The firm’s stock price and thus its value is dependent on: its future expected cash flows, the timing of the CFs and the risk associated with such CFs.

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Agency Relationships Agency relationship exist when one or more

persons (The principals) hire another person (The agent) to act on their behalf.

In corporations ,important agency relationship exist : Between stockholders and managers, and Between stockholders and creditors

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Agency ProblemsShareholders versus managers : Management is separate from ownership Agency problem arises when a manager own less

than 100%of the co.’s ownership Managers may make decisions that are not in line

with the goal of maximizing stockholders wealth ( may work less eagerly and tend to benefit themselves in terms of salary and perks)

Agency costs: Are costs associated with agency problem such as reduced stock price and “perks”

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Mechanisms Used To Ensure That Managers Act In The Shareholders Best Interest

Managerial compensation (Incentives) plans: include giving management performance shares, stock options or restricted stock grants.

The proper structuring of managerial incentives( All incentive compensation plans are designed to provide inducements to management to act in a manner that will contribute to stock price maximization as well as to attract and retain top-level executives )

The threat of firing. Shareholders intervention ( institutional shareholders

with large stakes in the firm) The threat of takeover ( in a hostile takeover, the

managers of the acquired firm generally are fired)

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Tactics That Managers Can Use To Ward Off a Hostile Takeovers : Hostile takeover : takeover of a company against the wishes of

current management and the board of directors. Tactics used by management include: - Scorched earth policy: technique used by a takeover- target

company to make itself unattractive to the acquirer.e.g it may agree to sell off the most attractive parts of its business (Crown Jewels) or it may schedule all debt to become due immediately after a merger.

- Poison Pill ; A move by a take over target company to make its stocks less attractive to an acquirer.e.g issue a new series of preferred stock that gives shareholders the right to redeem it at a premium price after a takeover.

- Greenmail (Bon Voyage Bonus); payment of a premium to a raider trying to take over a company through a proxy contest or other means.

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Agency Problems……………..cont Stockholders Versus Creditors

Creditors lend the firm at a certain interest rate based on expectations regarding the factors that determine the riskiness of the firm’s expected cash flows, such as: The riskiness of the firm’s existing assets The riskiness of future asset additions Present capital structure. Expected capital structure

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Stockholders Versus Creditors…..cont.Conflict develops if;

- Managers , acting in the interest of shareholders, take on projects with a greater risk than creditors anticipated.

-Raise the debt level higher than was expected.

* The above actions tend to reduce the value of debt outstanding.

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Agency Problem……………..cont. The goal of maximizing shareholders wealth

require fair play with the creditors and other stakeholders !!

Managers as agents of both the creditors and stockholders ,must act in a manner that is fairly balanced between the interest of these two classes of security holders

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Stakeholders Individual or entities that have interest in the

well-being of a firm such as: Stockholders Creditors Employees Customers and Suppliers

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Forms of businesses in other countries In the US : corporations are “open" companies, are publicly

traded and independent of each other and of the government. In England & Canada: most large companies are “open" and their

stocks widely dispersed among different investors . However two thirds of the traded stocks in England are owned by institutional investors.

In much of Continental Europe stock ownership is more concentrated. investor groups include families, Banks and other corporations.

In Japan & S.Korea firms belong to industrial groups These are organizations comprise of companies in different industries with common ownership interest which include firms necessary to manufacture and sell industrial products (a network of manufacturers,suppliers,retailers etc) examples are Toyota,Toshiba……