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Chapter 1

Finance Chapter 1 Notes

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Ryerson University
FIN 300
Michael Inglis

Finance 300 Chapter 1 - Notes What is Corporate Finance? 1. What long-term investment should you take on? - What lines of business? What sorts of buildings, machinery, equipment, research and development facilities will you need? 2. Where will you get the long-term financing to pay for your investment? - Will you bring in other owner or borrow the money? 3. How will you manage day to day financial activities? - Collecting from clients and paying clients/suppliers The Finance Manager - Striking feature of large corporations - owners(shareholders) are usually not directly involved in making business decisions. Financial Managers are hired in their position (they answer the 3 questions above) - Financial Management reports to the CFO -> COO -> CEO Capital Budgeting: The process of planning and managing a firm’s investment in long-term assets. - In capital budgeting, the financial manager tries to identify investment opportunities that are worth more to the firm than they will cost to acquire. - The value of the cash flow generated by an asset exceeds the cost of that asset. - For example, for a restaurant chain like Tim Hortons, deciding whether or not to open stores would be a major capital budgeting decision. Some decisions, such as what type of computer system to buy, might not depend so much on a particular line of business. - Financial managers must be concerned not only with how much cash they expect to receive but also with when they expect to receive it and how likely they are to receive it. Evaluating the size, timing, and risk of future cash flows is the essence of capital budgeting. Capital Structure: The mix of debt and equity maintained by a firm. - The financial manager has two concerns in this area; First - How much should the firm borrow; that is, what mixture is best? The mixture chosen affects both the risk and value of the firm. Second, what are the latest expensive sources of funds for the firm? - What percentage of the firm’s cash flow goes to the creditors and what percentage goes to shareholders? Management has a great deal of flexibility in choosing a firm’s financial structure. - Besides deciding on the financing mix, the financial manager has to decide exactly how and where to raise the money. The expenses associated with raising long-term financing can be considerable, so different possibilities must be carefully evaluated. Working Capital Management: Planning and managing the firm’s current assets and liabilities. - Working capital refers to short-term assets (inventory) and its short-term liabilities (money owed to suppliers). - This involves a number of activities, all related to the firm’s receipt and disbursement of cash Forms of Business Organization Sole Proprietorship: A business owned by a single individual - Simplest and is the least regulated form of organization - Negatives: the owner has unlimited liability for business debts; meaning that creditors can look beyond assets to the proprietor’s personal assets for payment. Partnership: A business formed by two or more CO-owners. - In a general partnership all the partners share in gains and losses, and all have unlimited liability for all partnership debts, not just some particular share. - General partners have unlimited liability for partnerships debts, and the partnership concludes when a general partner wishes to sell out or dies. All income is taxed as a personal income to the partners, and the amount of equity that can be raised is limited to the partner’s combined wealth. - In a limited partnership, one or more general partners have unlimited liability and runs the business for one or more limited partners who don’t actively participate in the business. - The primary disadvantages of sole proprietorship and partnership as forms of business organization are (1) unlimited liability for business debts on the part of the owners, (2) limited life of the business, and (3) difficulty of transferring ownership. Corporation: A business created as a distinct legal entity owned by one or more individuals or entities. - Corporations can borrow money and won property, can sue and be sued, and can enter into contracts. - Advantages: Ownership (represented by shares of stock) can be readily transferred, and the life of the corporation is therefore not limited. - Are the reasons why the corporate form is superior when it comes to raising cash - While limited liability makes the corporate form attractive to equity investors, lenders sometimes view the limited liability feature as a disadvantage. If the borrower experiences financial distress and is unable to repay its debt, limited liability blocks lenders’ access to the owners’ personal assets. - The corporate form has a significant disadvantage because a corporation is a legal entity, it must pay taxes. Income Trust: - Starting in 2001, the income trust, a non-corporate form of business organization, grew in importance in Canada. Business income trusts (also called income funds) hold the debt and the equity of an underlying business and distribute the income generated to unit holders - their income is typically taxed only in the hands of unit holders. - Investors have viewed trusts as tax-efficient and have been generally willing to pay more for a company after it has converted from a corporation to a trust - this advantaged disappeared on Halloween 2006 * Table 1.1 - Summary of the Notes Above The Goal of Financial Management is to make money or add value for the owners. Possible Goals: 1. Survive in Business 2. Avoid financial distress and bankruptcy 3. Beat the competition 4. Maximize sales or market share 5. Minimize costs 6. Maximize profits 7. Maintain steady earnings growth - The goals above are all different, they fall into two classes. The first of these relates to profitability. The goals involving sales, market share, and cost control all related, at least potentially, to different ways of earning or increasing profits. - The second groups, involving bankruptcy avoidance, stability, and safety, relate in some way to controlling risk. The Goal of Financial Management What is a good financial management decision? - Good decisions increase the value of the stock; goal is to maximize the current value per share of existing stock. - Shareholders are entitled to what is left after employees, suppliers, and creditors are paid their due. If any of these go unpaid, the shareholders get nothing. If the shareholders are winning in the sense that the leftover portion is growing, it must mean that everyone else is winning also. - To make the market value of the stock a valid measure of financial decisions requires an efficient capital market. In an efficient capital market, security prices fully reflect available information. The market sets the stock price to give the firm an accurate report card on its decisions. A More General Goal - The total value of the stock in a corporation is simply equal to the value of the owners’ equity. Therefore, a more general way of stating our goal is to maximize the market value of the owners’ equity. The Agency Problem and Control of the Corporation Agency Relationships - The relationship between shareholders and management is called an agency relationship. Such a relationship exists whenever someone (the principle) hires another (the agent) to represent his or her interests. - Agency Problem: The possibility of conflicts of interests between the shareholders and management of a firm. Management Goals - Example: The new investment favorably impacts the share value, but it is a relatively risky venture. The owners of the firm may wish to take the investment because the stock value will rise, but management may not because of the possibility that things will turn out badly and management jobs will be lost. - If management does not take the investment, the shareholders may have lost a valuable opportunity; example of an agency cost. Agency costs refer to the costs of the conflict of interests between shareholders and management. These costs can be indirect or direct. An indirect agency cost is a lost opportunity. - Direct agency costs come in two-forms: the first is a corporate expenditure that benefits management but costs the shareholders (buying a jet). The second direct agency cost is an expense that arises from the need to monitor management actions. Paying outside auditors to assess the accuracy of financial statement information. Do Mangers Act in the Shareholders’ Interests? Managerial Compensation - Management frequently has a significant economic incentive to increase share value for two reasons: First, managerial compensation, particularly at the top, is usually tied to financial performance in general and often to the share value in particular. - The second incentive managers have relates to job prospects. Better performers within the firm get promoted. More generally, those managers who are successful in pursuing shareholder goals are in greater demand in the labour market and thus command higher salaries. - Excessive management pay and unauthorized management consumption are examples of agency costs. Control of the Firm - Control of the firm ultimately rests with shareholders. They elect the board of directors, who, in turn, hire and fire management. - Another way that management can be replaced is by a takeover. Example: Canadian Airlines’ CEO lost his job when the company was taken over by Air Canada. Poorly managed firms are more attractive as acquisitions than well- managed firms because a greater turnaround potential exists. Thus, avoiding a takeover by another firm gives management another incentive to act in the shareholders’ interest. - Large funds
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