CORPORATE FINANCECORPORATE FINANCE

J.D. Han

King’s College, UWO

CHAPTER ONE

Financial Management and the Financial Objectives of the Firm

1.1 Learning Objectives1.1 Learning Objectives

1) Define financial management, and give reasons why it is important.

2) Name examples/reasons why simple profit maximization is not a satisfactory economic objective for financial managers.

3) Discuss the main categories of criticisms of simple share price maximization as a corporate objective.

4.Examine agency relationships, and outline the potential associated costs.

1.2 What is Finance?1.2 What is Finance?

Finance has 3 aspects:

1) Making long-term investment decisions: “Capital Budgeting Decisions”

2) Making long-term financing decisions:“Capital Structure Decision” – Bonds, Loans or Equities?

3) Managing day-to-day activities:“Working Capital or Liquidity Management”

1.3 Forms of Business 1.3 Forms of Business OrganizationsOrganizations

1) Sole Proprietorship

2) Partnerships

3) Corporations

1) Sole Proprietorship1) Sole Proprietorship

Easy to establishOwned and operated by one individualIncome generated is taxed at the

proprietor’s personal tax rate Not recognized as a separate legal entityOwner faces unlimited liability with respect

to his/her business

2) Partnerships2) Partnerships

Involves two or more ownersNot recognized as a separate

legal entityPartnership income taxed as personal

incomeDetails of each partners responsibilities are

outlined in a partnership agreement

* * Two Types of PartnershipsTwo Types of Partnerships

General Partnerships- partners face unlimited

liability- partners are involved in

the day-to-day operation of the business

- partners are jointly liable for all the obligations of the partnership

Limited Partnerships- must have at least one

general partner involved in business

- limited partners cannot be involved in business operations

- liability is limited to the amount invested in the partnership

3) Corporations3) CorporationsProfits are taxed based on corporate tax ratesSeparation of Ownership and ManagementShareholders(Principals) exert influence over

the corporation by electing board of directors and thereby management(Agents)

Shareholders have limited liabilities

**Advantages versus Disadvantages Advantages versus Disadvantages of Corporationsof Corporations

AdvantagesEasy to raise funds: Risk-SharingEasy to transfer ownership: Stock MarketLimited Liability of Owners: Risk-Taking VentureTax Advantages

DisadvantagesPrincipal-Agent Problem –Agency Cost; “Bad Corporate Governance” – Social CostHostile Take-Over: Transactions Cost

1. 4 Importance of Good 1. 4 Importance of Good Financial ManagementFinancial Management

Provide long range financial planningParticipate in formulating and implementing

broad corporate strategyAnalyze the risk and profitability of a firm

•Qualifications of Financial Qualifications of Financial ManagersManagers

Because financial officers are oriented towards the future performance of an organization, they must:

1. be familiar with financial and accounting theory

2. be involved in the development of information systems

3. have analytical techniques

4. have a background in economics

1. 6 Objectives of Financial 1. 6 Objectives of Financial Management: Maximizing Management: Maximizing

Shareholder WealthShareholder Wealth

The objective of financial management is to maximize shareholder wealth as reflected in share prices.

•three issues of financial three issues of financial managementmanagement

1) Profit Versus Return On Capital:

no particular ratio (index) tells all about the company

2) Timing of Capital Flows:

Time value of money

3) Uncertainty: Risk Evaluation and Management

Profits must be viewed in relation to capital invested in order to guide financial decision-making: Ratio Analysis

The return on capital invested by the firm should always be commensurate with reasonable shareholders’ expectations

1) Profit 1) Profit VersusVersus Return On Return On CapitalCapital

2) Timing of Cash Flows2) Timing of Cash Flows

The occurrence of profits is not a one-time event

operational objectives should incorporate the "time value of money“ to allow profits to be compared across different time periods: Long-Term Analysis.

3) Risk3) Risk

Profits are subject to risk Investors generally demand a higher

expected return, or risk premium in order to invest in risky securities: Risk Evaluation( Expected Returns; Risk Premium Theories; Certainty Equivalence Theory); Risk Management (Portfolio Diversification Strategy; Hedging Strategy)

1.7 Role of Management in 1.7 Role of Management in Imperfect InformationImperfect Information

Management serves as an arbitrator and moderator between conflicting interest groups or stakeholders and objectives.

Creditors, managers, employees and customers hold contractual claims against the firms revenues

Shareholders have residual claims against the company

* * Information Asymmetry and Information Asymmetry and Principal-Agent ProblemPrincipal-Agent Problem

Separation of Ownership from Management Principal (Owners=Shareholders) versus

Agents(Managers) Principal-Agent Problem is due to Information

Asymmetry (about what is going on in the firm) between the two

Agency costs incurs to resolve Principal-Agent Problem through Monitoring and Instituting Incentive Compatibility

•Agency CostsAgency Costs

Recognizes that agency relationship does not work without friction and shareholders may incur losses

Occurs when managers choose not to maximize shareholders’ wealth for their own self-gains

**Specific Types of Agency Specific Types of Agency CostsCosts

Stock option compensation- Example: Management is given the opportunity to

buy shares in the company at a given price Cost from Conflict of interests- Example: Potential conflict of interest between

shareholders and debt holders whose best interests may conflict at times

-Lender’s Liability Equitable Subordination Clause in U.S. Corporate Law (and way to go for Canada)

1.9 Summary1.9 Summary

1. With the increasing complexity and uncertainty in the marketplace, finance is emerging as the business function that holds the corporation together at the top management level.

2. If markets are "perfect", (perfect competition, perfect information, rational market participants, no externalities), economic theory has demonstrated that an efficient allocation of resources will result.

1.9 Summary1.9 Summary

3. Profits have to be viewed in relation to capital invested because the general theory of profit maximization ignores the amount of capital invested to generate a given profit, different patterns of profits across time, and the risks inherent in future profit projections.

4. Market preferences are expressed in prices— share prices in our case. The issue of valuation is concerned with establishing what determines the value of shares in capital markets.

SummarySummary5. Maximization of share prices can be criticized on the

grounds that real markets are not perfect, that management also has responsibilities to other groups that have legitimate interests in the firm (employees, customers, and various sectors of government), and that the objective of economic efficiency is too narrow.

6. In a competitive market environment, profitability and good shareholder relations are a prerequisite to the pursuit of many additional concerns, and high share prices will assure the firm's continued access to financial markets for further expansion.