Ch 1: Introduction to Ch 1: Introduction to Financial Financial ManagementManagement

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Issues in Ch 1Issues in Ch 1

Careers in financeCareers in finance Forms of business organizationForms of business organization The goal of financial managementThe goal of financial management The agency problemThe agency problem

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Careers in FinanceCareers in Finance

Corporate financeCorporate finance Investment, Money ManagementInvestment, Money Management Banking (commercial banking, investment Banking (commercial banking, investment

banking)banking) InsuranceInsurance Real estate financeReal estate finance International financeInternational finance Derivatives (e.g., futures, options, swaps, etc)Derivatives (e.g., futures, options, swaps, etc) Risk managementRisk management Financial planning and personal financeFinancial planning and personal finance …………....

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Forms of Business Forms of Business OrganizationsOrganizations Sole proprietorshipSole proprietorship PartnershipPartnership CorporationCorporation

Google - HistoryGoogle - History On August 1998: The first funding for Google was a $100,000

contribution from Andy Bechtolsheim, co-founder of Sun Microsystems, given to a corporation which did not yet exist.

On June 7, 1999: Equity funding totaling $25 million was given by rival venture capital firms Kleiner Perkins Caufield & Byers and Sequoia Capital.

In January 2004, Google hired investment bankers, Morgan Stanley and Goldman Sachs Group to arrange the IPO.

Google's IPO took place on August 19, 2004. Google's IPO took place on August 19, 2004. – A total of 19,605,052 shares were offered at a price of A total of 19,605,052 shares were offered at a price of $85$85 per share. per share.– Of that, 14,142,135 were floated by Google and 5,462,917 by selling Of that, 14,142,135 were floated by Google and 5,462,917 by selling

stockholders. stockholders. – The sale raised US$1.67 billion, and gave Google a The sale raised US$1.67 billion, and gave Google a

market capitalization of more than $23 billion. of more than $23 billion.– The vast majority of Google's 271 million shares remained under The vast majority of Google's 271 million shares remained under

Google's control. Google's control. – Many of Google's employees became instant paper millionaires.Many of Google's employees became instant paper millionaires.

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Sole ProprietorshipSole Proprietorship

A single individual owns all the firm’s A single individual owns all the firm’s assets directly and indirectly assets directly and indirectly responsible for all its liabilities.responsible for all its liabilities.

Simplest type of business without Simplest type of business without outstanding stock offeringsoutstanding stock offerings

easy to own and operateeasy to own and operate limited ability to raise capital or limited ability to raise capital or

access to capital marketaccess to capital market difficult to transfer ownershipdifficult to transfer ownership difficult to measure the value of the difficult to measure the value of the

firm objectivelyfirm objectively unlimited liabilityunlimited liability Personal tax on profitsPersonal tax on profits

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PartnershipPartnership

Similar to a proprietorship with Similar to a proprietorship with multiple ownersmultiple owners

general partner vs. limited general partner vs. limited partnerspartners

limited access to capital marketslimited access to capital markets Income taxed as personal income Income taxed as personal income

to the partnersto the partners

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CorporationCorporation

Legally a “person” that is separate and Legally a “person” that is separate and distinct from its owners, the distinct from its owners, the shareholders. shareholders. – Two controlling groups: Stockholders and Two controlling groups: Stockholders and

ManagersManagers– separation of ownership and managementseparation of ownership and management

more difficult to startmore difficult to start easier access to raising capitaleasier access to raising capital easy to transfer ownershipeasy to transfer ownership easy to measure the value of the firm easy to measure the value of the firm

objectivelyobjectively

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CorporationCorporation

limited liability limited liability to investorsto investors– Limited Liability: A type of liability that does Limited Liability: A type of liability that does

not exceed the initial amount a person not exceed the initial amount a person invested into a business entity.invested into a business entity.

double taxationdouble taxation– A A tax law that causes the same earnings to law that causes the same earnings to

be subjected to taxation twice. A be subjected to taxation twice. A company's income is taxed initially and company's income is taxed initially and then the shareholders and then the shareholders and investors are are taxed on the distributions they receive from taxed on the distributions they receive from the company. the company.

– President Bush reduce tax rates on President Bush reduce tax rates on dividend in 2002.dividend in 2002.

Unlimited vs. Limited Unlimited vs. Limited LiabilityLiability

Business AssetBusiness Asset Personal AssetPersonal Asset

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Asset AssetDebt + Equity

Debt + Equity

$100K

Bank Loan $60K

Equity $40K

House $200K

Mortgage $170K

Equity $30K

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Corporate StructureCorporate Structure

Sole Proprietorships

Corporations

Partnerships

Unlimited Liability

Personal tax on profits

Limited Liability

Corporate tax on profits +

Personal tax on dividends

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Types of U.S. FirmsTypes of U.S. Firms

There are four different types of firms in the United States. As (a) and (b) There are four different types of firms in the United States. As (a) and (b) show, although the majority of U.S. firms are sole proprietorships, they show, although the majority of U.S. firms are sole proprietorships, they generate only a small fraction of total revenue, in contrast to corporations.generate only a small fraction of total revenue, in contrast to corporations.Source: www.bizstats.comSource: www.bizstats.com

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Role of the Financial Role of the Financial ManagerManager

Financialmanager

Firm'soperations

Financialmarkets

(1) Cash raised from investors(2) Cash invested in firm

(3) Cash generated by operations(4a) Cash reinvested

(4b) Cash returned to investors

(1)(2)

(3)

(4a)

(4b)

FinancialMarkets

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What should a financial What should a financial manager try to manager try to maximize?maximize?

Maximize profit?Maximize profit? Maximize employee, supplier, creditor, and Maximize employee, supplier, creditor, and

other stakeholder wealth?other stakeholder wealth? Maximize shareholder wealth? Maximize shareholder wealth? (more (more

important)important) – Shareholder wealth is measured by the market value Shareholder wealth is measured by the market value

of the firm's common stock (i.e., the price that the of the firm's common stock (i.e., the price that the stock trades in the market).stock trades in the market).

– Maximize the current value per share of the existing Maximize the current value per share of the existing stock or to maximize the market value of the existing stock or to maximize the market value of the existing owners’ equityowners’ equity

– Enron and WorldCom were very profitable in the past, Enron and WorldCom were very profitable in the past, but why they are almost extinct now? but why they are almost extinct now?

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What Should Managers What Should Managers Maximize?Maximize?

Problems with Profit Maximization Problems with Profit Maximization – Profits is not Necessarily Cash Flows, or Profits is not Necessarily Cash Flows, or

Ignores the Timing of Returns due to Ignores the Timing of Returns due to accrual basis accountingaccrual basis accounting

– Accounting profits can easily be Accounting profits can easily be manipulated manipulated

– Ignores RiskIgnores Risk– Focuses on Short-Term ProfitsFocuses on Short-Term Profits

Maximize Shareholder WealthMaximize Shareholder Wealth– Focus on Maximization of Focus on Maximization of Stock PriceStock Price, ,

rather than Profitsrather than Profits– Account for RiskAccount for Risk

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Agency problemAgency problem

In typical corporations, ownership can be spread In typical corporations, ownership can be spread over a huge number of stockholders.over a huge number of stockholders.

Therefore, agency relationship exists when Therefore, agency relationship exists when someone (the principal, or stockholders) hires someone (the principal, or stockholders) hires another (the agent, or CEO, CFO, and other another (the agent, or CEO, CFO, and other managers) to represent his or her interest.managers) to represent his or her interest.

Then, the Then, the separation of ownership and separation of ownership and management creates agency problem, or Princmanagement creates agency problem, or Principal-ipal-Agent problem.Agent problem.– Agency problem: the possibility of conflict of

interest between the owners and management of a firm. Mangers won’t work for the firm’s owners unless it’s in their best interest.

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Two Key Groups in Two Key Groups in CorporationCorporation

The agency problem: Mangers won’t work for the firm’s owners unless it’s in their best interest!

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How are entrenched How are entrenched managers harmful to managers harmful to shareholders?shareholders?

Management act in the best interest of Management act in the best interest of themselves, not in the best interest of themselves, not in the best interest of shareholders.shareholders.– Management consume perks such as lavish Management consume perks such as lavish

offices and corporate jets, excessively large offices and corporate jets, excessively large staffs, and memberships at country clubs.staffs, and memberships at country clubs.

More critically, management engages in More critically, management engages in non-value increasing activities.non-value increasing activities.– Management accepts projects (or Management accepts projects (or

acquisitions) to make firm larger, even if its acquisitions) to make firm larger, even if its value after the event may go down.value after the event may go down.

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CEO Stock OptionsCEO Stock Options

Why are the corporations willing to Why are the corporations willing to provide stock options to CEOs?provide stock options to CEOs?– The separation of ownership and

management creates conflicts (or agency cost) between managers and shareholders.

– One way to mitigate conflicts is to offer stock options to mangers.

– That is, in order to reduce agency cost, managerial compensation is closely tied to share value of the firm.

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Stock Options in Stock Options in Compensation PlansCompensation Plans Gives owner of option the right to Gives owner of option the right to

buy a share of the company’s stock buy a share of the company’s stock at a specified price (called the at a specified price (called the exercise price) even if the actual exercise price) even if the actual stock price is higher.stock price is higher.

Usually can’t exercise the option Usually can’t exercise the option for several years (called the for several years (called the vesting period or the expiration).vesting period or the expiration).

A Hypothetical A Hypothetical Example of CEO Stock Example of CEO Stock OptionOption

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$20

$50

($50 -$20)*100,000 shares = $3 million profit!

CEO Pays in Corporate CEO Pays in Corporate AmericaAmerica

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Practice QuestionPractice Question

Which one of the following is an advantage Which one of the following is an advantage of ownership of a corporation over that of of ownership of a corporation over that of a sole proprietorship? a sole proprietorship?

A)A) The owners of a corporation have limited The owners of a corporation have limited liability for the firm's debts. liability for the firm's debts.

B)B) A corporation is the easiest form of a business A corporation is the easiest form of a business to start. to start.

C)C) A corporation is difficult to access to capital A corporation is difficult to access to capital markets. markets.

D)D) A corporation is less regulated than a sole A corporation is less regulated than a sole proprietorship. proprietorship.

E)E) The profit of a corporation is subject to double The profit of a corporation is subject to double taxation.taxation.

Practice QuestionPractice Question

The primary goal of financial The primary goal of financial management is to maximize which management is to maximize which one of the following for a one of the following for a corporation?corporation?A.A. Current profitsCurrent profits

B.B. Market shareMarket share

C.C. Number of shares outstandingNumber of shares outstanding

D.D. Market value of existing stockMarket value of existing stock

E.E. Revenue growthRevenue growth

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