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Fundamentals of Corporate Finance

by Robert Parrino, Ph.D. & David S. Kidwell, Ph.D.


Created by
Babu G. Baradwaj, Ph.D Lawrence L. Licon, Ph.D

Chapter 1 The Financial Manager and the Firm

Copyright 2008 John Wiley & Sons

Chapter 1

The Financial Manager and the Firm

Chapter 1 The Financial Manager and the Firm

Copyright 2008 John Wiley & Sons

Quick Links
The Role of the Financial Manager Forms of Business Organization Managing the Financial Function

The Goal of the Firm


Agency Conflicts: Separation of Ownership and Control The Importance of Ethics in Business Exhibits

Chapter 1 The Financial Manager and the Firm

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Exhibit 1.1: Cash Flow Diagram

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The Role of the Financial Manager


It is all About Cash Flows
A firm generates cash flows by selling the

goods and services produced by its productive assets and human capital.
The firm can pay the remaining cash, called

residual cash flows, to the owners as a cash dividend, or reinvest the cash in the business.

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The Role of the Financial Manager


It is all About Cash Flows
A firm is unprofitable when it fails to generate

sufficient cash flows


Firms that are unprofitable over time will be

forced into bankruptcy by their creditors.


In bankruptcy, the company will either be

reorganized, or the companys assets will be liquidated


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The Role of the Financial Manager


Three Fundamental Decisions in Financial Management
The capital budgeting decision:

Which productive assets should the firm buy? finance manager invest in a capital project only if benefits>cost (1.2 table)
The financing decision (capital structure

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decision ) How should the firm finance or pay for assets? Decision related to proportion of equity & debt. 7

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Exhibit 1.2: How Financial Managers Decisions Affect the Balance Sheet

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The Role of the Financial Manager


Three Fundamental Decisions in Financial Management
Working capital management decisions:

How should day-to-day financial matters be managed? Dividend decision

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DECISIONS, RETURN, RISK, AND MARKET VALUE

Capital Budgeting Decisions Return Market Value of the Firm Dividend Decisions Risk Working Capital Decisions
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Capital Structure Decisions

Centre for Financial Management , Bangalore

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Legal Forms of Business Organization


Sole Proprietorship
No legal distinction between personal and

business income for a sole proprietor.


All business income is taxed as personal

income.
A sole has unlimited liability for all business

debts and other obligations of the firm.

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Legal Forms of Business Organization


Partnership
Has the same basic advantages and

disadvantages as a sole proprietorship.


When a transfer of ownership takes place

the partnership is terminated, and a new partnership is formed.


The problem of unlimited liability can be

avoided in a limited partnership

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Legal Forms of Business Organization


Corporation
In a legal sense, it is a person distinct from

its owners.
The owners of a corporation are its

stockholders, or shareholders.
A major advantage of the corporate form of business is that stockholders have limited liability

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Legal Forms of Business Organization


Corporation
Public corporations can sell their debt or

equity in the public securities markets.


Private corporations are held by a small

number of investors

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FORMS OF BUSINESS ORGANISATION

1)Sole Proprietorship
One owner Very simple Unlimited liability The firm has no separate status from a legal and tax

2)Partnership (Partnership act 1932)


Two or more owners Fairly simple Unlimited or limited liability The firm has a separate status

3)Private Limited Company


Upto 50 owners Not too complex Limited liability A distinct legal person Chapter 1 The Financial Manager and the Firm No transferability of shares 15

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Public Limited Company

Many owners
Somewhat complex Limited liability

Distinct legal person


Free transferability of shares

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Exhibit 1.3: Simplified Corporate Organization Chart

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Managing the Financial Function


Chief Executive Officer (CEO)
Ultimate management responsibility and

decision-making power in the firm.


Reports directly to the board of directors, which

is accountable to the companys owners.

Go to Exhibit 1.3
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Managing the Financial Function


Chief Financial Officer (CFO)
Responsibility for the best possible financial

analysis that is presented to the CEO


CFOs key financial reports

The Controller prepares financial

statements, oversees the firms cost accounting systems, prepares taxes, and works closely with the firms external auditors.
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Managing the Financial Function


Chief Financial Officer (CFO) CFOs Key Financial Reports The Treasurer looks after the collection and disbursement of cash, invests excess cash, raises new capital, handles foreign exchange, and oversees the firms pension fund managers

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Managing the Financial Function


Chief Financial Officer (CFO) CFOs Key Financial Reports
The Internal Auditor is responsible for in-

depth risk assessments, performing audits of high-risk areas

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Managing the Financial Function


External Auditors
Provide an independent annual audit of the

firms financial statements.


Ensure that the financial numbers are

reasonably accurate, and accounting principles have been consistently applied

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Managing the Financial Function


Audit Committee
Approves the external auditors fees and

engagement letter. The external auditor cannot be fired or terminated without the audit committees approval.

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The Goal of the Firm


What Should Management Maximize?
Minimizing risk or maximizing profits

without regard to the other is not a successful strategy.


Why not maximize profits? Either Return /risk This decision depends on risk

taking ability of owner.

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The Goal of the Firm


What Should Management Maximize?
Why not maximize profits? To a skilled accountant, however,

a decision that increases profits under one set of accounting rules can reduce it under another.
Accounting profits are not

necessarily the same as cash flows.

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The Goal of the Firm


What Should Management Maximize?
Why not maximize profits? Profit maximization does not tell

us when cash flows are to be received.


Profit maximization ignores the

uncertainty or risk associated with cash flows.


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The Goal of the Firm


Maximize the Value of the Firms Stock Price When analysts and investors determine the value of a firms stock, they consider The size of the expected cash flows
The timing of the cash flows
The riskiness of the cash flows. The mechanism for determining stock

prices overcomes all the cash-flow objections raised


Go to Exhibit 1.4
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The Goal of the Firm


Can Management Decisions Affect Stock Prices?
YES!!!

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Exhibit 1.4: Major Factors Affecting Stock Prices

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Agency Conflicts: Separation of Ownership and Control


Ownership and Control
For large corporations, the ownership of the

firm is spread over huge number of shareholders and the firms owners may effectively have little control over management management may make decisions that benefit their self-interest rather than those of the stockholders.

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Agency Conflicts: Separation of Ownership and Control


Agency Relationships
An agency relationships arises whenever

one party, called the principal, hires another party, called the agent

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Agency Conflicts: Separation of Ownership and Control


Do Managers Really Want to Maximize Stock Price?
Shareholders own the corporation, but

managers control the money and have the opportunity to use it for their own benefit.

Agency Costs The costs of the conflict of interest between the firms owners and its management.

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Agency Conflicts: Separation of Ownership and Control


Aligning the Interests of Management and Stockholders
Management Compensation a significant portion of management

compensation is tied to firm performance (e.g. stock price)

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Agency Conflicts: Separation of Ownership and Control


Aligning the Interests of Management and Stockholders
Control of the firm if the interests of the manager and the firm are

not aligned, then eventually the firm will under perform relative to its true potential

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Agency Conflicts: Separation of Ownership and Control


Aligning the Interests of Management and Stockholders An Independent Board of Directors Lack of board independence is a key factor in the misalignment between board members and stockholders interests

Go to Exhibit 1.5 & 1.6


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Agency Conflicts: Separation of Ownership and Control


Sarbanes-Oxley and Other Regulatory Reforms
Greater Board Independence

Establish Internal Accounting Controls Establish Ethics Program Expand Audit Committees Oversight Powers

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The Importance of Ethics in Business


Business Ethics A societys ideas about what actions are right and wrong. Are Business Ethics Different?
Traditions of morality are relevant to business

and financial markets


Corruption in business creates inefficiencies

in an economy
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The Importance of Ethics in Business


Types of Ethical Conflicts in Business
Conflicts of Interest conflict between individuals personal or

institutional gain and the obligation to serve the interest of another party.
Information Asymmetry one party in a transaction has

information that is unavailable to the other parties


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The Importance of Ethics in Business


1)The Law is Not Enough 2)Serious Consequences
Legal cost of ethical mistakes can be

extremely high.

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Exhibit 1.3: Simplified Corporate Organization Chart

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Exhibit 1.4: Major Factors Affecting Stock Prices

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Exhibit 1.5: Corporate Governance Regulations

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