Download CHAPTER 1 An Overview of Financial Management

CHAPTER 1 - B&H
An Overview of Financial Management
Pankaj Agrrawal, Ph.D.
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Career Opportunities
Issues of the New Millennium
Forms of Businesses
Goals of the Corporation
Agency Relationships
1-1
Better than avg. drivers, pls. stand up.
Finance Concepts are Simple, the
Behavioral Aspects are not…
A $ today is better than a $ tomorrow
(concept of TVM)
 Buy Low sell High (arbitrage – fear and greed,
I say fear of losing and missing are the only
motivators)
 No free lunch (the world of risk and
return, CAPM, APT)
 Prices do not instantaneously adjust to all new
information (random price path  irrationality)
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1-2
Let’s take a 5-7 minute “Initial” Exam:
PA: If you can get an asset worth $100
for $90, what’s the instant profit you just
made?
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If your initial investment declines by 50%,
what percentage increase will bring you back
to even?
If the average annual returns for the past two
years has been –50% and +50%, what is the
return on your investment over those two
years?
If your investment has trebled in value, what is
the associated percentage rise?
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Financial Management Issues
of the New Millennium
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The effect of
changing
technology: lower
costs, efficient,
barriers to entry
lowered
The globalization
of business
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Relevance of Finance and
Globalization:
If you are a Doctor / Engineer– how does FM
affect you?
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For self decisions – day to day
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Good business organization
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If you are a Nebraska Homebuilder– how does
Globalization affect you? (discuss KO)
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Interest rates –global- housing demand
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Local economy – wheat demand - global
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Career Opportunities in
Finance
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Money and capital markets
Financial management
Investments
Financial Intermediaries: Banking
Corporate Finance: Managing the financing of
corporations
Investment Management: Portfolio Management
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Role of Finance in a Typical
Business Organization
Board of Directors
President
VP: Sales
VP: Finance
Treasurer
VP: Operations
Controller
Credit Manager
Cost Accounting
Inventory Manager
Financial Accounting
Capital Budgeting Director
Tax Department
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Responsibility of the Financial
Staff
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Maximize stock value by:
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Forecasting and planning
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Investment and financing decisions
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Coordination and control
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Transactions in the financial markets
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Managing risk
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Percentage of Revenue and Net Income
from Overseas Operations for 10 WellKnown Corporations, 2001
Company
% of Revenue
from overseas
% of Net Income
from overseas
Coca-Cola
60.8
35.9
Exxon Mobil
69.4
60.2
General Electric
32.6
25.2
General Motors
26.1
60.6
IBM
57.9
48.4
JP Morgan Chase & Co.
35.5
51.7
McDonald’s
63.1
61.7
Merck
18.3
58.1
3M
52.9
47.0
Sears, Roebuck
10.5
7.8
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Alternative Forms of Business
Organization
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Sole proprietorship
Partnership
Corporation
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Sole proprietorships &
Partnerships
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Advantages
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Ease of formation
Subject to few regulations
No corporate income taxes
Disadvantages
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Difficult to raise capital
Unlimited liability
Limited life
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Corporation
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Advantages
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Unlimited life
Easy transfer of ownership
Limited liability
Ease of raising capital
Disadvantages
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Double taxation (Delaware 300k+ companies)
Cost of set-up and report filing
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Financial Goals of the Corporation
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The primary financial goal is shareholder
wealth maximization, which translates to
maximizing stock price.
 Do firms have any responsibilities to society
(safety, pollution, antitrust- price gouging,fair
hiring) at large? (DSEFX [ETF=KLD-show how to
locate], SPX, VICEX – 3yrs)
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Priced out of mkt
Shunned by investors
Social objectives have to be mandated – role of Govt
Is stock price maximization good or bad for
society (efficient production, new technology,new
jobs)?
Should firms behave ethically?
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1-15
Is stock price maximization the same as profit
maximization (Rev-Cost)?
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No, despite a generally high correlation
amongst stock price, EPS, and cash flow.
Current stock price relies upon current
earnings, as well as future earnings and
cash flow.
Some actions may cause an increase in
earnings, yet cause the stock price to
decrease – risk impact (and vice versa).
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Agency relationships
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An agency relationship exists whenever
a principal hires an agent to act on their
behalf.
Within a corporation, agency
relationships exist between:
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Shareholders and managers
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Shareholders and creditors
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Shareholders versus Managers
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Managers are naturally inclined to act in their
own best interests (ICC).
But the following factors affect managerial
behavior:
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Managerial compensation plans
Direct intervention by shareholders (free rider
problem – Satellite Dish example)
The threat of firing
The threat of takeover (poison pills, greenmail)
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Shareholders versus Creditors
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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.
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Factors that affect stock price
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Projected cash flows
to shareholders
Timing of the cash
flow stream
Riskiness of the cash
flows
1-20
Basic Valuation Model
CF1
CF2
CFn
Value 
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1
2
(1  k)
(1  k)
(1  k)n
n
CFt
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.
t
t 1 (1  k)
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A=P(1+r)^n => 110 = 100(1+10%) ^1 yr
For 2 years CF is: 10/(1.1)+(10% of 100)/(1.1*1.1)+100/(1.21) = (11+10+100)/1.21 =>100
Or 9.09+10/1.21+100/1.21= 9.09+8.26+82.64 =>99.99 (A $ one yr from now is more valuable than two yrs
from now)
To estimate an asset’s value, one estimates the cash flow for each
period t (CFt), the life of the asset (n), and the appropriate
discount rate (k)
Throughout the course, we discuss how to estimate the inputs
and how financial management is used to improve them and thus
maximize a firm’s value.
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Factors that Affect the Level
and Riskiness of Cash Flows
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Decisions made by financial managers:
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Investment decisions
Financing decisions (the relative use of
debt financing)
Dividend policy decisions
The external environment
1-22
Austrian Economic Cycle
Liquidity is the fuel behind financial market fluctuations
BOND (Liquidity flows out of bonds and into stocks and then the real economy)
PRICES
FALL INFLATION
RISES
SHORT-TERM
INTEREST
RATES RISE
STOCK
PRICES
Capacity constraints
FALL
hit. Employment
PROPERTY
greater than natural
PRICES
level. Leading inflation
gauge up. Industrial
FALL
production high.
RECESSION
INFLATION
BOND RISES
PRICES
FALL
ECONOMIC
RECOVERY
STOCK
PRICES
RISE
Economic variables
begin over heating
Earnings growth strong.
BOND
PRICES
RISE
Industrial commodity
prices soften
GDP growth
decreases, economic
variables weaken.
Industrial commodity
prices begin to
strengthen
SHORT-TERM
RATES FALL
INFLATION
FALLS
Economic variables
look very weak
The cycle depicts when liquidity is rising or falling.
An expansion in liquidity during disinflation washes through the most liquid assets first
and then into the economy.
6 Year Cycle
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HW
Questions Ch 1: 1-1, 1-5, 1-6, 1-7, 1-8
and ST -1 (solutions at end of book, in
Appx B)----
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Read Ch 4, self review ST questions
page 159
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