Finance 200 Financial Management

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Finance 200Financial Management

• Drake University
• Summer 2005

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Financial Management

• The process by which business managers make
  financial decisions today that have consequences
  that extend through time.
• What is the Goal of Financial Management?

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Goal of Financial Management

• Increase the value of the firm
• How do you measure Value??
• Value should reflect the amount that all expected
  future cash flows generated by the firm are worth
  today.
• Possible Value measures
• Stock Price
• The Present Value of its Future Cash Flows

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Firm Value and Stock Prices

• Is maximizing the value of the firm the same as
  maximizing the stock price?
• Only if we assume that management works to
  protect all the stakeholders in the firm

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The Firms Stakeholders

1. Shareholders
2. Employees
3. Bondholders
4. Society

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Management and Stockholders

• The Principal / Agent Problem
• Whenever owners (principals) hire managers
  (agents) to operate the firm there is a potential
  conflict of interest. The managers have an
  incentive to act in their own best interest
  instead of the owners (Shareholders)
• It is possible for stock price to increase
  because of managers actions without the value of
  the firm increasing.

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Principal / Agent Examples

• Manipulation of earnings to increase the managers
  bonus
• Blocking a merger that adds value to shareholders
  to preserve the managers job
• Others?

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Management and StockholdersOther Problems

• Often there is a distance between managers and
  shareholders that causes their interestes to not
  be aligned.
• Lack of monitoring by shareholders
• Lack of expertise on the board
• Lack of independence on the board
• Small ownership stake of directors
• Best Case
• Managers focus on stock price maximization and
  are compensated in a manner consistence with
  increasing shareholder value.

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Conflicts between stockholders and bondholders

• Stock Price maximization may increase risk of
  default. For example Undertaking a risky project
  that increases value if successful, but also
  increases possibility of default if it fails.
• Best Case
• Lenders are protected via covenants in
• the debt contracts and management
• considers both bond and stock holders
• in decision making.

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Managers and Financial Markets

• The Information Problem
• Firms may intentionally mislead financial markets
• The Market Problem
• Even if information is correct, the markets may
  not react properly
• Best Case
• Management does not mislead the markets and
• the markets interpret information correctly

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Firms and Society

• Management decisions may have social costs
  (intentional and non intentional)
• pollution, Johns Manville and Asbestos
• Best Case
• Management acts in the best interest
• of society, and attempts to be a good corporate
  citizen.

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Our Assumption

• In class we will assume that management attempts
  to act in the best interest of all stakeholders.
  Therefore, stock price maximization and firm
  value maximization are basically the same thing.

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Social Welfare

• Does firm value maximization benefit society?
• The owners of the firms stock are society
• Stock price maximization promotes efficiency and
  allocation of resources
• Promotes growth and employment

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Financial Management

• The process by which business managers make
  financial decisions today that have consequences
  that extend through time with the goal of
  increasing firm value.

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Financial Decision Making

• Capital Budgeting
• What projects should the firm undertake?
• How do the projects impact frim value?
• Capital Structure
• How are the projects financed?
• Working Capital Management
• How do cash flows provide for the daily
  operations of the firm?

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Goal of Financial ManagementA Better Definition

• Maximize the value of the firm as determined by
  the present value of its expected cash flows,
  discounted back at a rate that reflects both the
  riskiness of the firms projects and the financing
  mix used to fund the projects.

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Outline of the class Part 1

• Maximize the value of the firm as determined by
  the present value of its expected cash flows,
  discounted back at a rate that reflects both the
  riskiness of the firms projects and the financing
  mix used to fund the projects.
• Time Value of Money (Measuring PV)
• Applying PV to Stocks and Bonds

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Outline Part 2

• Maximize the value of the firm as determined by
  the present value of its expected cash flows,
  discounted back at a rate that reflects both the
  riskiness of the firms projects and the financing
  mix used to fund the projects.
• Financial Statement Analysis
• Estimating Cash Flows
• Long Term Planning

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Outline Part 3

• Maximize the value of the firm as determined by
  the present value of its expected cash flows,
  discounted back at a rate that reflects both the
  riskiness of the firms projects and the financing
  mix used to fund the projects.
• The relationship between Risk and Return
• CAPM (one approach to measuring risk and return)
• Cost of Capital (Based on Stock and Bond
  Valuation and risk and return)

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Outline Part 4

• Maximize the value of the firm as determined by
  the present value of its expected cash flows,
  discounted back at a rate that reflects both the
  riskiness of the firms projects and the
  financing mix used to fund the projects.
• Estimating a Projects Cash Flows (Based on
  Financial Statements)
• Capital Budgeting / Evaluating Projects using NPV
  (Estimates of Cash Flows, financial statement
  analysis, and the cost of capital)