Lecture 2 raising cash in financial markets (the financing decision); investing cash (capital budgeting decision); generating cash from operation allocating cash flows Capital Budgeting Decision ◦ Decision to invest in tangible or intangible assets. …also called the Investment Decision Financing Decision ◦ Raising money that the firm needs for its investments and operations. Capital Structure ◦ The mix of long term debt and equity financing. (2) (1) Firm's Financial operations Manager Real assets (4a) (4b) (3) (1) Cash raised from investors (2) Cash invested in firm (3) Cash generated by operations (4a) Cash reinvested (4b) Cash returned to investors Investors Action: Manage cash flow (1), (2), (4), (5). • Investment: (2) ⇒ (3). • Financing and payout: (1), (4), (5). • Risk management: (1) and (5). Objective: Create value for shareholders. Forecasting and planning Major investment and financing decisions Coordination and control Dealing with capital markets The goal of the financial manager must be consistent with the mission of the corporation. What is the generally accepted mission of a corporation? • To maximize firm value shareholder’s wealth (as measured by share prices) “To achieve sustainable growth, we have established a vision with clear goals: Maximizing return to shareholders while being mindful of our overall responsibilities” (part of Coca-Cola’s mission statement) “Our final responsibility is to our stockholders …when we operate according to these principles, the stockholders should realize a fair return” (part of Johnson & Johnson’s credo) “Optimize for the long-term rather than trying to produce smooth earnings for each quarter” While managers have to cater to all the stakeholders (such as consumers, employees, suppliers etc.), they need to pay particular attention to the owners of the corporation i.e. shareholders. If managers fail to pursue shareholder wealth maximization, they will lose the support of investors and lenders. The business may cease to exist and ultimately, the managers will lose their jobs! What do we mean by Ethics? Give examples of recent financial scandals and discuss what went wrong from an ethical perspective. Ownership & control: “the large corporation is owned by so many shareholders that no single shareholder owns a significant proportion of the outside stock. Therefore no single shareholder has the power to really control the actions of the officers of the corporation”. “Negligence and profusion … must always prevail in such a company.” The bulk of the dividends go to outside shareholders. All the major decisions are taken by the corporate officers. The outside shareholders are unable to control the corporate officers. The interests of the shareholders and the corporate officers diverge significantly. Shareholders: PROFIT Corporate Officers: POWER, PRESTIGE, PERSONAL WEALTH Senior managers may be in a position to enrich themselves at the expense of the shareholders. Management acts as an agent for the owners (shareholders) of the firm. An agent is an individual authorized by another person, called the principal, to act in the latter’s behalf. Jensen and Meckling developed a theory of the firm based on agency theory. Agency Theory is a branch of economics relating to the behavior of principals and their agents. Principals must provide incentives so that management acts in the principals’ best interests and then monitor results. Incentives include, stock options, perquisites, and bonuses. Agency relationship exists when one or more persons (known as the principal) contracts with one or more persons (the agent) to make decisions on their behalf. In a corporation, the managers are the agents and the stockholders are the principal. Agency problems arise when there is conflict of interest between the stockholders and the managers. Such problems are likely to arise more when the managers have little or no ownership in the firm. Examples: ◦ Not pursuing risky project for fear of losing jobs, stealing, expensive perks. All else equal, agency problems will reduce the firm value. All agency relationships involve moral hazard. “the principal and the agent may have different objectives and the principal cannot easily determine whether the agent’s reports and actions are being taken in pursuit of the principal’s goals or self-interested behaviour.” 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 Managers are naturally inclined to act in their own best interests. But the following factors affect managerial behavior: ◦ Managerial compensation plans ◦ Direct intervention by shareholders ◦ The threat of firing ◦ The threat of takeover 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. Agency relationship ◦ Principal hires an agent to represent their interest ◦ Stockholders (principals) hire managers (agents) to run the company Agency problem ◦ Conflict of interest between principal and agent Management goals and agency costs 27 costs include the less than optimum share value for shareholders and costs incurred by them to monitor the actions of managers and control their behaviour. 28 Managerial compensation ◦ Incentives can be used to align management and stockholder interests ◦ The incentives need to be structured carefully to make sure that they achieve their goal Corporate control ◦ The threat of a takeover may result in better management Other stakeholders 29 1. 2. 3. Monitoring (Examples: Reports, Meetings, Auditors, board of directors, financial markets, bankers, credit agencies) Compensation plans (Examples: Performance based bonus, salary, stock options, benefits) Others (Examples: Threat of being fired, Threat of takeovers, Stock market, regulations such as SOX) The above will help to reduce agency problems/costs. A dollar received today is more valuable than a dollar received in the future. ◦ We can invest the dollar received today to earn interest. Thus, in the future, you will have more than one dollar, as you will receive the interest on your investment plus your initial invested dollar. We only take risk when we expect to be compensated for the extra risk with additional return. Higher the risk, higher will be the expected return. Profit is an accounting concept designed to measure a business’s performance over an interval of time. Cash flow is the amount of cash that can actually be taken out of the business over this same interval. It is possible for a firm to report profits but have no cash. For example, if all sales are on credit, the firm may report profits even though no cash is being generated. Financial decisions in a firm should consider “incremental cash flow” i.e. the difference between the cash flows the company will produce with the potential new investment it’s thinking about making and what it would make without the investment. Investors respond to new information by buying and selling their investments. The speed with which investors act and the way that prices respond to new information determines the efficiency of the market. In efficient markets like United States, this process occurs very quickly. As a result, it is hard to profit from trading investments on publicly released information. Investors in capital markets will tend to react positively to good decisions made by the firm resulting in higher stock prices. Stock prices will tend to decrease when there is bad information released on the firm in the capital market. Name the four principles of finance . Explain one of those.
