Chapter 1: Finance and the Firm

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Finance and the Firm
Chapter 1
8/26/09
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Learning Objectives

• The field of finance
• Financial Management
• The basic goal of a business firm
• Legal and ethical challenges for financial
  managers
• Corporate form of business

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The Field of Finance

• Financial Management (Businesses)
• Analyze and forecast a firms performance,
  results of operations
• Evaluate investment opportunities
• Arrange financing
• Financial Markets and Institutions (Stockbrokers,
  banks, retirement funds, insurance companies)
• The flow of funds through institutions
• Markets in which financial assets are sold

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The Field of Finance

• Investments (Money managers, investment firms)
• Locate, select, and manage moneyproducing
  assets.
• Impact of Interest rates on the flow of funds for
  all of the above
• How the Fed controls inflation economic growth

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Financial Management

• Managing the Balance Sheet
• Liabilities and equity represent sources of
  funds. (Capital structure)
• Assets represent uses of funds.
• Liabilities represent a debt claim.
• Equity represents an ownership claim.

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Financial Management

• Capital Budgeting

• Deals with the firms investment in long-term
  real assets
• e.g., in what projects and fixed assets should
  the firm invest?

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Financial Management
LT Liabilities Equity

• Capital Structure Policy

• Deals with long-term financing of the firms
  investment activities
• e.g., what mix of long term debt and equity will
  the firm use?
• Hedging

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Financial Management
ST Assets

• Working Capital Management

• Deals with management of short-term (current)
  assets and short-term (current) liabilities.
• e.g., will the firm purchase supplies on credit
  or pay cash? How much inventory?

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Basic Goal of the Business Firm

• The primary financial goal of the business firm
  is to maximize the wealth of the firms owners
  (or the value of the firm) by increasing share
  price.
• This is not necessarily the same as maximizing
  current profits. (Short term in nature can be
  detrimental to the future, i.e. cut R D.

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Maximizing thevalue of a firm?

• The value of a firm is determined by what people
  are willing to pay for it. (price for individual
  shares of stock)
• The financial manager should make decisions that
  are financially sound, that increase the value of
  the firm
• In addition, decisions that also cause people to
  think more favorably about the firm, i.e.,
  policies regarding employees, minorities, equal
  rights, the environment, their local community,
  etc.

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Factors that affect the value of a firms stock
price

• Cash flows (Axiom 3

• Cash is king, pays the bills
• Sales or profits not the same as cash inflows
  you cant spend them

• Timing of cash flows (Axiom 2)

• Cash received sooner is better than cash received
  later time value of money

• Risk (Axiom 1)

• Definite cash inflows are generally preferred to
  uncertain cash inflows
• Risky cash flow valued lower than definite cash
  flows not all risk is the same

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Legal and Ethical Challenges

• Agency issues (Axiom 7)

• Managers are agents for the firms owners but
  they may have interests that conflict with those
  owners. i.e., backdating stock options
• These agency conflicts impose costs such as the
  cost of accounting, audits, etc.)
• Sarbanes Oxley Act of 2002

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Legal and Ethical Challenges

• The interests of society as a whole may not
  coincide with the interests of owners of a firm.

• Societys best interests take precedence over the
  Companys. i.e., costs of disposing of toxic
  waste reduce owners profits.
• There may be goodwill generated by voluntary
  actions that benefit society. i.e., recycling,
  youth programs, Target)
• The right thing must be done in spite of the
  dollar cost to the company

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Government

• Government often imposes rules that force
  companies to respond to the best interests of
  society.
• Environmental Protection Agency (EPA)
• Securities Exchange Commission (SEC)
• Federal Trade Commission (FTC)

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Forms of Business Organization

• Corporation

• A legal person separate and distinct from its
  owners

• Liability limited to invested
• Permanency
• Transferability of Ownership
• Better Access to Capital Markets

• Advantages

• Disadvantages

• Double Taxation
• Time and Cost of Incorporation