Advanced Financial Management FIN 451 Course Instructor: Dr. Farasat Ali Shah Bukhari Overview of Course Outline • Overview of Financial Management • Risk and Return: Some Lessons from Capital Market History • Options • Financial Planning • Cost of Capital • Dividend Policy • Raising Capital • Enterprise Risk Management • Mergers & Acquisitions • Project Management & Evaluation • International Corporate Finance • Financial Leverage • Project Presentation • Case Studies Course Evaluation Activity Grading Break-up Final Exam 40% Mid-Term Exam 20% Quizzes 15% Assignment 10% Project 10% Class Participation 5% Chapter 1 Introduction to Corporate Finance Learning Objectives • Define the basic types of financial management decisions and the role of the financial manager • Explain the goal of financial management. • Articulate the financial implications of the different forms of business organization. • Explain the conflicts of interest that can arise between managers and owners. Outline • What is corporate finance? • The goal of financial management • The agency problem and control of the corporation • Financial markets What is Corporate Finance • Imagine that you were to start your own business. No matter what type you started, you would have to answer the following three questions in some form or another: • What long-term investments should a firm take on? • Where will a firm get the long-term financing to pay for your investment? • How will a firm manage it’s everyday financial activities? The Financial Manager • In a large corporation • The owner not directly involved in decision making process. • Managers need to make decisions for the best interests of the owners. • Thus, financial manager would be in charge of answering the three questions that were raised in the preceding section • The financial management function • Vice president finance or chief financial officer (CFO) A simplified Organization Chart 1. Financial Management Decisions • The first question concerns the firm’s long-term investments. • Capital budgeting: The process of planning and managing a firm’s long-term investments. • Analysis of potential additions to fixed assets. • Long-term decisions; involve large expenditures. • Very important to firm’s future. • Firms use different techniques to evaluate projects. Example • The types of investment opportunities that would typically be considered depend in part on the nature of the firm’s business. For a large retailer such as Walmart, deciding whether to open another store would be an important capital budgeting decision • For a software company such as Oracle or Microsoft, the decision to develop and market a new spreadsheet program would be a major capital budgeting decision 2. Financial Management Decisions • The second question for the financial manager concerns ways in which the firm obtains and manages the long-term financing it needs to support its long term investments • Capital Structure • The mixture of debt and equity maintained by the firm. • Setting the capital structure involves a trade-off between risk and return. • Using more debt will raise the risk borne by stockholders. • However, using more debt generally increases the expected return on equity Example • The financial manager has two concerns in this area: • First, how much should the firm borrow? That is, what mixture of debt and equity is best? • Second, what are the least expensive sources of funds for the firm? • If we picture the firm as a pie, then the firm’s capital structure determines how that pie is sliced—in other words, what percentage of the firm’s cash flow goes to creditors and what percentage goes to shareholders. 2. Financial Management Decisions • Capital Structure: • Managers, seek to find the capital structure that strikes a balance between risk and return so as to maximize the stock price. • Firms have a great deal of flexibility in choosing a financial structure. The question of whether one structure is better than any other for a particular firm is the heart of the capital structure issue. 3. Financial Management Decisions • The third question concerns working capital management: • A firm’s short-term assets and liabilities • Current assets and current liabilities. • Managing the firm’s working capital • Is a day-to-day activity that ensures that the firm has sufficient resources to continue its operations 3. Financial Management Decisions • Working capital management: Some questions must be answered. 1. How much cash and inventory should we keep on hand? 2. Should we sell on credit? If so, what terms will we offer, and to whom will we extend them? 3. How will we obtain any needed short-term financing? Will we purchase on credit, or will we borrow in the short term and pay cash? Conclusion • The three areas of corporate financial management we have described— capital budgeting, capital structure, and working capital management—are very broad categories. • Each includes a rich variety of topics, and we have indicated only a few questions that arise in the different areas Forms of Business Organization • Sole proprietorships • Partnerships • Corporations Forms of Business Organization • Sole proprietorships & Partnership • Advantages • Ease of formation • Subject to few regulations • No corporate income taxes • Disadvantages • Difficult to raise capital • Unlimited liability • Limited life Forms of Business Organization • Corporations: a business created as a distinct legal entity composed of one or more individuals or entities. • Advantages • Unlimited life • Easy transfer of ownership • Limited liability • Ease of raising capital • Disadvantages • Double taxation • Cost of set-up and reporting filing Forms of Business Organization • Limited Liability Company (LLC) • The goal of this entity is to operate and be taxed like a partnership but retain limited liability for owners. • so an LLC is essentially a hybrid of partnership and corporation. Revision • What are the three forms of business organization? • What are the primary advantages and disadvantages of sole proprietorships • and partnerships? • What is the difference between a general and a limited partnership? • Why is the corporate form superior when it comes to raising cash? Who make the decisions? • Owners (typically in small businesses). • Professional managers Possible goals of financial management • Survive • Beat the competition • Maximize sales • Maximize net income • Maximize market share • Minimize costs • Maximize the value of (stock) shares The “appropriate” goal of financial management • Maximize the value of (stock) shares is the right goal. • Why? • The goal of maximizing the value of the stock avoids the problems associated with the different goals we listed earlier. The “appropriate” goal of financial management • The stockholders in a firm are residual owners. • They are entitled to only what is left after employees, suppliers, and creditors (and anyone else with a legitimate claim) are paid their due. • This means this goal is mutually beneficial to all stakeholders. Shareholders and other stakeholders • Customers • Suppliers • Employees • Creditors (bondholders, banks, debtholders) • Government: tax and regulations • Community (local / global) • Owner/shareholder The agency problem • Agency relationship: • Principals (stockholders) hire agents (managers) to run the company. • Agency problem: • Conflict of interest between principals and agents. • This occurs in a corporate setting. • The source of agency problems is the separation of ownership and control of the firm. Agency costs • Direct costs: (1) unnecessary expenses, such as a corporate jet, and (2) monitoring costs. • Indirect costs. For example, a manager may choose not to take on the optimal investment. He/she may prefer a less risky project to secure current job. Do Managers Act in the Stockholders’ Interests? • It depends on • How closely are management goals aligned with stockholder goals? • Can managers be replaced if they do not pursue stockholder goals? Corporate governance • Compensation: • Incentives used to align management and stockholder interests. • Corporate control: • Managers may take the threat of a takeover • Pressure from other stakeholders Financial Market • It is a market where financial instruments are traded • “In this market, financial assets (securities) such as stock and bonds can be purchased or sold” • It is a vibrant avenue where buyers and sellers meet • There are at least two participants in Financial markets • Surplus Units (Extra to give), they are also known as Savers or Investors • Deficit Units (Spend more than received), they are looking for funds and are known as Users or Borrowers Financial Markets • The primary advantages of the corporate form of organization are that: • Ownership can be transferred more quickly and easily than with other forms. • Money can be raised more readily. • Both of these advantages are significantly enhanced by the existence of financial markets Cash Flows between the Firm and the Financial Markets Primary Vs Secondary Markets • Primary market: • The term refers to the original sale of securities by governments and corporations. • Public and private offering • Secondary Market: • Markets where securities are bought and sold after the original sale • Dealer vs action market
