mba: financial management lecture 1 1chara charalambous

MBA: FINANCIAL MANAGEMENT

LECTURE 1

Chara Charalambous 2

AGENTA

PART AWhat Is A Corporation? PART BThe Role of The Financial Manager Who Is The Financial Manager? PART CSeparation of Ownership and Management


PART A


Alternative Forms of Business Organization

There are three main forms of business

organization :

ProprietorshipPartnershipCorporation


What Is A Corporation?

Sole proprietorships: Small enterprises are owned and managed by a single individual.

Partnership: Two or more people join to own and manage partnership.

Corporations: is a legal entity created by a status. It is separate and distinct from its owners and managers. As such can have a name and enjoy many of the legal powers of natural persons. For e.g. can acquire and exchange property, enter contracts, sue and be sued.


Sole ProprietorshipAdvantages:

It is easy and inexpensively formed but in most cases must be licensed by the municipality in which it operates. Is the cheapest business to form.

Subject to few government regulationsNo corporate income taxes, it is taxed like an individual

Limitations:The owner has unlimited personal liability on business

debts which can result in losses that exceed the money the owner has invested in the company.

Difficult to raise capital because the firm’s financial strength is based on the financial strength of the sole trader. The equity money are limited to the owner’s personal wealth.

Transferring ownership is difficult – selling of the business is similar to selling a house and the proprietor has to seek out and negotiate with a potential buyer.

Limited life of the business equal to the life of the individual who created it.


PartnershipA partnership has roughly the same advantages

and limitations as a proprietorship.Partners are ‘jointly and severally’ liable for

any losses that the business might make. Regarding liability the partners can lose all of

their personal assets even those not invested in the business because under partnership law all each partner is liable for the business’ debts. Thus if any partner is unable to meet his or her prorate claim in the event the partnership goes bankrupt, the remaining partners must cover the unsatisfied claims.


Every general partner is jointly liable with the other partners for the debts and obligations of the firm incurred while he is a partner. Although the liability is joint, each partner is individually liable for the whole amount due by the firm.

Traditionally the big accounting firms have been partnerships.

Legally, the partnership is dissolved if one of the partners dies or withdraws.


Corporation Advantages:

Unlimited life: it can continue after its original owners are dead.

Easy transfer of ownership: ownership can be divided into shares of stock which in turn can be transferred far more easily than the other two form of organizations.

Limited liability: the loss of a shareholder in case of bankruptcy is limited to the amount he/she initially invested

Ease of raising capital in the financial markets for the above reasons (sell shares e.t.c), because investors will have limited liability and since many will invest funds can be invested in growth opportunities which will increase the value of the firm.

Chara Charalambous

There are two main disadvantages for the corporations:Disadvantages:

Double taxation of earnings: the earnings of the corporation are taxed and then the earnings paid as dividends are taxed again as income to the stockholders

Setting up a corporation and filing required lawyer to prepare regulations and rules regarding the management of the company and reports given to the government , is more complex and time consuming than the other two forms of organizations.

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Corporate Structure

Sole Proprietorships Partnerships

Corporations

Specific and Unlimited Liability Personal tax on profits

Can be endless (separation of ownership and management) Limited Liability Corporate tax on profits + Personal tax on dividends

Corporation: ‘An ingenious device for obtaining individual profit without individual responsibility.’—AMBROSE BIERCEThe Devil’s Dictionary


Things that a corporation can do and a partnership can’t

It can raise money by selling new shares to investors and it can buy those shares back.

One corporation can make a takeover bid for another and then merge the two business.


In a limited partnership, limited partners contribute capital and have liability limited to that amount of capital; they cannot lose more than they put in. There must, however, be at least one general partner in the partnership, whose liability is unlimited. Limited partners do not participate in the operation of the business; this is left to the general partner(s). The limited partners are strictly investors, and they share in the profits or losses of the partnership according to the terms of the partnership agreement. This type of arrangement is frequently used in financing real estate ventures.


Corporations: Issue shares. In the beginning, the shares may all be held by a small group of investors, perhaps the company’s manager and a few sponsors. In this case the shares are not publicly traded and the company is closely held. Eventually, when the firm grows and new shares are issued to raise additional capital, its shares will be widely traded. Such corporations are known as public companies.


Who are the shareholders?

People that hold only a few shares: have a few number of votes and receive a tiny proportion of profits and dividends.

Giant pension funds and Insurance companies that hold a huge number of shares: have a large number of votes, and a large proportion of profits and dividend.


Organizing a Business

Sole Proprietorship Partnership Corporation

Who owns the business The manager Partners Shareholders

Are managers and owners separate?

No No Usually

What is the owner’s liability?

Unlimited Unlimited Limited

Are the owner & business taxed separately?

No No Yes


A partnership, like a proprietorship, pays no income taxes. Instead, individual partners include their share of profits or losses from the business as part of their personal taxable income.


Board of directors

The board of directors is elected by the shareholders in order to represent the shareholders and manage the corporation → Separation of ownership and management

Some of these directors are executive and others are non-executive directors who are not employed by the firm.

The board of directors appoints top management and its role is to ensure that managers act in the best interest of the shareholders.


The Role of theNon-Executive Director

Essentially the role of a non-executive director is to provide what could be called a “creative contribution” to the board of directors by giving objective criticism and advice. Today it is widely accepted that non-executive directors have an important contribution to make to the effective running of many companies. As “The Cadbury Report”, produced in 1992, stated “they should bring an independent judgment to bear on issues of strategy, performance and resources including key appointments and standards of conduct”.(behaviour) There is no legal distinction between executive and non-executive directors. As a result, in the UK unitary board structure, non-executive directors essentially have the same legal duties, responsibilities and potential liabilities as their executive colleagues. Although it is understood non-executive directors cannot and do not give the same continuous attention to the business of the company, it is important that they show the same commitment to its success as the executive directors.


The Role of theNon-Executive Director

A non-executive director (NED) typically does not engage in the day-to-day management of the organization, but is involved in policy making and planning exercises. In addition, non-executive directors' responsibilities include the monitoring of the executive directors, and to act in the interest of any stakeholders. Also called external director, independent director and outside director.


” Of genuine importance is their independence from the management of the company and any of its “interested parties’’.

As a first point we would note that the great majority of private limited companies in the UK have not in the past appointed non-executive directors to their boards. In the main this was only relevant for publicly quoted companies and much larger private companies where, perhaps, there were very good reasons to make such appointments. This may have been to represent a finance house or a powerful minority shareholder. However, over the last few years we have seen an increasing trend for medium size and larger private companies to appoint non-executive directors.

The functions of non-executive directors:(a) independence(b) wide experience(c) specialist knowledge(d) personal merits.


PART B

Chara Charalambous 23The Role of Financial Manager

Financial Decisions Investment Decisions A successful firm generally has rapid growth in sales which

requires investment in plant, equipment and inventory. The financial manager must help decide on the specific assets to acquire and the best way to finance those assets. For example should the firm raise funds by borrowing (debt) or by selling stock (shares)? If the firm uses debt should be long term or short term?

Forecasting and planning Dealing with Financial markets Monitor, coordination and control Asset Management: Once assets have been acquired

(investment) and appropriate financing provided, these assets must still be managed efficiently. The financial manager is more concerned with the management of current assets than with that of fixed assets. A large share of the responsibility for the management of fixed assets would reside with the operating managers who employ these assets.


Role of The Financial Manager

Firm's Operations - purchase real assets

Financial Manager

Financial Markets (Investors hold the Financial assets issued by the firm)

(1) Cash raised from investors (2) Cash invested in firm(3) Cash generated by operations (4a) Cash reinvested (4b) Cash returned to investors

(1)(2)

(3)

(4a)

(4b)


Role of The Financial Manager

The fundamental financial objective of the firm is to maximize the value of the cash invested in the firm by its stockholders.

Stockholders are happy to contribute cash at arrow (1) only if the decisions made at arrow (2) generate at least adequate returns at arrow (3), i.e. the returns generated are at least equal to the returns that stockholders could earn by investing in financial markets


Who is the Financial Manager

…………………………common titlesCFO: Chief Financial OfficerTREASURER CONTROLLER ………………………..…….regular tasksFINANCIAL POLICY CORPORATE PLANNING CAPITAL BUDGETING PROCESS

Chara Charalambous 27Who is The Financial Manager?

Treasurer Cash management Raising Capital and capital budgetingBanking relationships Investors relationsInsurance/risk managementTax analysis and planningDividend paymentMaking financial plans

Controller

Cost AccountingCost ManagementPreparing of Financial statements General Ledger (payroll, accounts receivable/payable)Internal ControlGovernment reportingData processing

BOARD OF DIRECTORS

PRESIDENT(Chief Executive Officer)

VICE PRESIDENT Operations

VICE PRESIDENT of Finance

(or Chief Financial Officer)

VICE PRESIDENT Marketing


As the head of one of the three major functional areas of the firm, the vice president of finance, or chief financial officer (CFO), generally reports directly to the president, or chief executive officer (CEO). In large firms, the financial operations overseen by the CFO will be split into two branches, with one headed by a treasurer and the other by a controller.

The controller’s responsibilities are primarily accounting in nature. Cost accounting, as well as budgets and forecasts, concerns internal consumption. External financial reporting is provided to the stockholders.

The treasurer’s responsibilities fall into the decision areas most commonly associated with financial management: investment (capital budgeting, pension management), financing (commercial banking and investment banking relationships, investor relations, dividend payment), and asset management (cash management, credit management).

The organization chart may give you the false impression that a clear split exists between treasurer and controller responsibilities. In a well-functioning firm, information will flow easily back and forth between both branches. In small firms the treasurer and controller functions may be combined into one position, with a resulting commingling of activities.

In the job of Managerial Finance you have to deal with tasks such as: make decisions regarding business expansions and choosing what types of securities to issue to finance expansion, deciding the credit terms under which customers can buy, how much inventory the firm should keep, how much cash to keep on hand, whether to acquire other firms and how much of the firm’s earnings to keep into the business and reinvest versus pay out as dividends. (retain earnings)

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Managerial Finance

‘What role does finance play in the successful operation of a firm’.

Answer: Proper financial management (managerial finance) will help any business to provide better products to its customers at lower prices , pay higher salaries to its employees and still provide greater returns to its investors who put up the funds needed to form and operate the business. Because the national and worldwide economy consists of consumers , employees and investors, good financial management contributes to the well being of both individuals and the general population.

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Managerial Finance is the broadest of the three categories and the one with the greatest job opportunities because it is important in all types of business weather they are public or private ,deal with financial services or are manufacturers


Common Finance Terminology

Common Finance Terminology –Real assets –Financial assets / Securities –Capital markets and financial markets –Investment / capital budgeting –finance

Chara Charalambous 33Common Finance Terminology

Real assets: tangible (machinery, factories, offices,cars,buildings etc), intangible (technical expertise, trademarks, patents, etc)

Financial assets or Securities: bank loans, stocks (common stock and preference stock), bonds.

Capital markets / Money Markets / Financial Markets: refer to all sources of financing.

Investment/capital budgeting - financing

Chara Charalambous 34Why Financial Markets exist?

Financial assets exist in an economy because the savings of various individuals, corporations, and governments during a period of time differ from their investment in real assets. If savings equalled investment in real assets for all economic units in an economy over all periods of time, there would be no external financing, no financial assets, and no money or capital markets. Each economic unit would be self-sufficient. Current expenditures and investment in real assets would be paid for out of current income. A financial asset is created only when the investment of an economic unit in real assets exceeds its savings, and it finances this excess by borrowing or issuing stock. Of course, another economic unit must be willing to lend.

This interaction of borrowers with lenders determines interest rates. In the economy as a whole, savings-surplus units (those whose

savings exceed their investment in real assets) provide funds to savings-deficit units (those whose investments in real assets exceed their savings).

This exchange of funds is confirmed by investment instruments, or securities, representing financial assets to the holders and financial liabilities to the issuers.


Why Financial Markets exist?

A market is a place where goods and services are exchanged.

A financial market is a place where individuals and organizations wanting to borrow funds are brought together with those having a surplus of funds.

Financial markets are mechanisms by which borrowers and lenders get together


Financial Market Functions

Source of funding Investor liquidity Risk management Source of information


Financial markets can be broken into two classes – the money market and the capital market. The money market is concerned with the buying and selling of short-term (less than one year original maturity) government and corporate debt securities. The capital market, on the other hand, deals with relatively long-term (greater than one year original maturity) debt and equity instruments (e.g., bonds and stocks).

Primary market: a market where new securities are bought and sold for the first time (a “new issues” market).

Secondary market: a market for existing (used) securities rather than new issues.

Financial intermediaries: Financial institutions that accept money from savers and use those funds to make loans and other financial investments in their own name. They include commercial banks, savings institutions, insurance companies, pension funds, finance companies, and mutual funds


PART C

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Goals of the Corporation

Business decisions are not made without objectives: the primary goal is stockholder wealth maximization maximizing the value of the firm - the value of stock price – current value per share of the existing stock. This the most important job of financial manager.Maximizing market price per share


How do financial managers create value?

The short answer is that the firm should create more cash flow than it uses. The cash flows paid to bondholders and stockholders should be greater than the cash flows put into the firm by the bondholders and stockholders. From the stockholders point of view what is a good financial management decision? If we assume that stockholders buy stock because they seek to gain financially then; good decisions increase the value of the stock and poor decisions do the opposite.


SEPARATION OF OWNERSHIP AND MANAGEMENT

Managers make decisions → advantages and disadvantages

Advantages: I. Practical necessity due to the large number of

shareholders →no way all of them to be actively involved in management.

II. It allows share ownership to change without interfering with the operation of the business.

III. It allows the firm to hire professional managers.


Do managers operate for the best interest of the stockholders or they are taking advantage of them?

Managers of course have also other objectives: Personal satisfaction – high salaries, employees

welfare – safe working environment and in the good of the community and of society at large – avoid polluting the air or water, produce safe products e.t.c.

It is difficult to know how managers act!


SEPARATION OF OWNERSHIP AND MANAGEMENT

Disadvantages: Agency costs Different objectives between: o Management Vs Shareholders o Shareholders Vs banks and other lenders o Top management Vs. operating management

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Agency Relationships

An agency relationship exists whenever a principal (person) hires an agent to act on their behalf.

Within corporations, agency relationships exist between:◦Stockholders and managers, and◦Stockholders and creditors.◦Top Management Vs Operational Management


The agency problem

The agency problem occurs when financial managers make decisions which are not consistent with the objectives of the company’s stakeholders.

It arises because: 1. There is a separation of ownership and control: agents

(financial managers) are given the power to manage and control the company by the principals (stakeholders: shareholders, creditors and customers).

2. The goals of agents are different from those of the principals.

3. Principals do not get full information about their company from the agent or the market (asymmetric information).

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Stockholders versus ManagersManagers are naturally tending to

act in their own best interests.But the following factors affect

managerial behavior:◦The threat of firing◦The threat of takeover. In an antagonistic

takeover the managers of the acquired firm generally are fired and any who are able to stay on ,lose the power they had prior to the acquisition.

◦Structuring managerial incentives: Firms are tying managers compensation to the company’s performance and this motivates managers to operate in a manner consistent with stock price maximization.


o Some people suggest that the primary monitoring of managers comes not from the owners but from the managerial labour market. They argue that efficient capital markets provide signals about the value of a company’s securities, and thus about the performance of its managers. Managers with good performance records should have an easier time finding other employment (if they need to) than managers with poor performance records.


Top Management Vs Operational Management

Senior management has to think of ways to motivate junior management and all other employees for the benefit of the firm. (e.g. bonuses)

Creditors decide to loan money to a corporation based on the riskiness of the company, its capital structure (how mush debt and how much own funds) and expectations of the future riskiness and future capital structure. All of these factors will affect creditors when determining the level of the interest rate they will charge in the company. Stockholders, however, have control of such decisions through the managers .Since stockholders will make decisions based on their best interest, a potential agency problem exists between the stockholders and creditors. They might try to take on new projects that are risky.

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Stockholders versus Creditors

But the following factors hold on stockholders from unethical decisions:

If creditors see that a firm will try to take advantage of them in unethical ways they will either refuse to deal with the firm or else will require a much higher than normal rate of interest to compensate for the risks of such ‘tricky’ actions. Thus firms that try to deal unfairly with creditors either lose access to the debt markets or are charged with higher interest rates, both of which decreases the long run value of the stock.

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Managers as agents of both the creditors and the stockholders must act in manner that is fairly balanced between the interest of these two classes of security holders.

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Thank you

Do you now understand the task of Financial Manager?

mba: financial management lecture 1 1chara charalambous

Documents

business debts

business equal

cheapest business

financial manager

chara charalambousagenta

financial markets

limited liability

financial management