Finance 3310

Lecture Notes

Lecture 1

 

FINANCE - is a subset of economics that deals with the allocation of resources across time. In a general sense,

Price ---> interest rates

Quantity ---> cash flows

The focus of this course is corporate finance:

CORPORATE (BUSINESS) FINANCE - is a subset of finance which is concerned with investing and financing decisions of firms. (See `corporate finance' handout and T1.5) The financial manager faces two questions:

What assets should the firm buy or invest in? --> Investment decision

How should the firm finance its assets? --> Financing decision

 

Consider a condensed balance sheet where current liabilities have been subtracted from current assets to create net working capital (NWC).

NWC (CA - CL) L-T Debt
Fixed Assets Equity
Total Assets Total Debt & Equity

Your book discusses three management decisions:

1) NWC mgmt - current assets & liabilities

2) investment decision - long-term assets

3) financing decision - long-term debt & equity

 

Organizational Form

A corporation is a legal entity which is separate and distinct from its owners. A partnership and sole proprietorship are, in general, indistinguishable from their owners. This separation has several legal and economic consequences.

 

Characteristics:

i) limited liability - a corporation has limited liability. This means that the most a shareholder can lose is whatever he/she paid for the shares. With sole proprietorships and partnerships, liability is unlimited. This means personal assets are subject to the debts of the company. More recently, limited liability companies (LLC's) and limited partnerships have decreased personal exposure for these organizational types.

ii) unlimited life - a corporation has unlimited life. Sole proprietorships and partnerships typically end with the death of the owner or a partner.

iii) transferability of ownership - in general, shares of a corporation may be bought and sold easily in financial markets. The transfer of ownership in a proprietorship or partnership usually involves selling the whole business (proprietorship) or approval of the partners (partnership). Transferability of ownership is particularly important for financial reasons, as it makes it much easier for a corporation to raise capital. How would a partnership or sole proprietorship raise capital?

iv) separation of ownership and control - in general, those who own the corporation (S/H) are a different group of people than those who make the day-to-day decisions regarding allocation of corporate resources (management). This separation has advantages and disadvantages:

• Advantage: shareholders can specialize in risk bearing, while management can specialize in managing the corporation. Owners do not have to know how to manage.

• Disadvantage: managers may pursue goals which are inconsistent with the goals of shareholders.

What are the goals of managers? Of shareholders? What should they be? We will examine these questions shortly

v) has to pay taxes - corporations must pay taxes. This leads to the concept of `double taxation' because a dollar of pretax corporate earnings are taxed once at the corporate level, and then at the personal level if they are paid out as dividends.

 

$1 corporate EBT -> tax -> Net Income-> div --> pers. income -> tax

 

The goal of Financial managment

A. What are some possible goals of financial management?

• Maximize profit or net income

• Maximize sales or market share

• Maximize the size of the firm

• Maximize employee welfare; safeguard the environment

• Grow

• Survive or avoid bankruptcy

B. What should the goal be?

• Maximize the value of shares

• Maximize shareholder wealth

• Maximize the value of the firm

Why are the goals in A inappropriate? Why are the goals in B appropriate?

What happens when management pursues goals other than those listed in B? ==> agency problems

T1.4

THE AGENCY PROBLEM

What do we mean by an agency relationship? This is a relationship whereby one person (agent) is employed to carry out an objective of another person (principal). In the context of a corporation, management has been hired by shareholders to maximize the value of the firm. A `generic' corporate organizational structure appears below:

Shareholders -> owners and risk bearers

|

Board of Directors -> agents of shareholders who approve and monitor management decisions

|

Management -> make day-to-day decisions regarding allocation of corporate resources

Now, what is the potential problem with an agency relationship? The problem is that management may pursue goals which are inconsistent with maximizing the value of the firm. As an example, management might:

• maximize management compensation

• maximize the size of the firm (`empire building')

• shirk (similar to first)

There are several costs associated with this agency problem. These `agency costs' include:

• loss of shareholder value (direct costs)

• monitoring costs

Monitoring costs involve all those costs incurred in an effort to monitor management behavior. These include the cost of audited financial statements, the cost of special board committees, and so on.

What are possible solutions to this agency problem? One solution is rather obvious when one thinks about how the problem arises. The problem arises when management pursues goals which are inconsisent with the goal of shareholders. The trick, then, is to align management goals with shareholder goals. How do you give management an incentive to maximize the value of shares? Make shares a large part of owners compensation. Thus we have observed the trend whereby share ownership, usually through options, has become an increasing portion of total management compensation.

Another solution to the problem includes the market for management, both internal and external. Management faces competition for its job both from within the corporation and from without. One only needs to read the WSJ to notice the frequent changes in management in corporate America.

Sometimes management becomes entrenched and have so much power that managerial markets do not work. In these situations the only solution may be the `market for corporate control.' The market for corporate control involves transactions in which control over the corporation is changed, or significantly modified. This would include

When control is not literally changed, incentives are usually realigned.

T1.4

FINANCIAL MARKETS

What is the role of a financial market? In general, to bring together suppliers and demanders of capital. In economics the quantity supplied and demanded depends on price, while in financial markets the quantity supplied and demanded is a function of rates. Corporate equities and debt are traded in financial markets. (See T1.5) Thus financial markets serve not only as a source of capital, but financial markets also value corporate securities.

B. Money vs. capital markets - money markets involve short-term, highly liquid and relatively safe securities. Capital markets are markets for longer term, less liquid and riskier securities, such as the bonds and stocks which corporation issue. Money markets tend to be `wire networks' whereas capital markets often involve physical exchanges, such as the New York Stock Exchange (NYSE).

C. Primary market - a primary market transaction is where securities are orginally issued, and capital raised by corporations or the government. Primary market transactions increase the supply of securities. Newly issued securities usually have to be registered with the Securities and Exchange Commission (SEC).

D. Secondary market - secondary markets involve trading of existing securities. Secondary market transactions neither raise capital nor change the supply of securities. Markets may be either dealer markets or auction markets, with a trend toward electronically connected dealer markets. While many stocks and bonds trade on the NYSE, there is significant volume on `over the counter markets' (OTC). OTC markets are electronically connected dealer markets.

 

MULTINATIONAL CORPORATIONS & INTERNATIONAL FINANCE

A multinational corporation is a corporation with significant 'overseas' production or sales. As an example, IBM has significant overseas operations.

General Considerations:

Additional Risks:

Financial Considerations:

 

ETHICS

Potential ethics issues:

Ethical issues are 'normative' issues. That is, they involve value judgments: what 'ought' to be versus what 'is.' Finance (and economics) are objective. They deal with what 'is.'In general, most of us in the 'business' school are not professionally trained to teach ethics. The source of this training is in 'liberal arts.' Ideally, the business manager would have a good foundation in both liberal arts and business.

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