FINANCE IN A CANADIAN SETTING Sixth Canadian Edition

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FINANCE IN A CANADIAN SETTING Sixth Canadian
Edition

• Lusztig, Cleary, Schwab

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• CHAPTER ONE
• Financial Management and the Financial Objectives
  of the Firm

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Learning Objectives

• 1. Define financial management, and give two
  reasons why it is important.
• 2. Name three reasons why simple profit
  maximization is not a satisfactory economic
  objective for financial managers.
• 3. Discuss the two main categories of criticisms
  of simple share price maximization as a corporate
  objective.

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Learning Objectives

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

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What is Finance?

• Finance is defined into three broad functional
  categories
• Making long-term investment decisions
• Making long-term financing decisions
• Managing day-to-day activities

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Forms of Business Organizations

• Sole Proprietorship
• Partnerships
• Corporations

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Sole Proprietorship

• Easy to establish
• Owned and operated by one individual
• Income generated is taxed at the proprietors
  personal tax rate
• Not recognized as a separate legal entity
• Owner faces unlimited liability with respect to
  his/her business

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Partnerships

• Involves two or more owners
• Not recognized as a separate
• legal entity
• Partnership income taxed as personal income
• Details of each partners responsibilities are
  outlined in a partnership agreement

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Two 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

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Corporations

• Dominate in terms of assets and sales
• Recognized as separate entities
• Profits are taxed based on corporate tax rates
• Transfer of ownership is relatively easy
• Shareholders exert influence over the corporation
  by electing board of directors

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Importance of Good Financial Management

• Provide long range financial planning
• Participate in formulating and implementing broad
  corporate strategy
• Analyze the risk and profitability of a firm

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Duties of Financial Managers

• Because financial officers are oriented towards
  the future performance of an organization, they
  must
• be familiar with financial and accounting theory
• be involved in the development of information
  systems
• have analytical techniques
• have a background in economics

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Objectives of Financial Management

• The three issues of financial management are
• Profit Versus Return On Capital
• Timing Versus Return on Capital
• Risk

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Profit Versus Return On Capital

• Profits must be viewed in relation to capital
  invested in order to guide financial
  decision-making
• The return on capital invested by the firm should
  always be commensurate with reasonable
  shareholders expectations

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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.

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Risk

• Profits are subject to risk
• Investors generally demand a higher expected
  return, or risk premium in order to invest in
  risky securities

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Maximizing Shareholder Wealth

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

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Role of Management

• 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

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Agency 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-gain

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Types of Agency Costs

• Stock option compensation
• - Example Management is given the opportunity to
  buy shares in the company at a given price
• Conflict of interest
• - Example Potential conflict of interest between
  shareholders and debt holders whose best
  interests may conflict at times

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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.

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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.

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Summary

• 5. 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.