MGMT640 - Financial Decision Making for Managers

MGMT640 - Financial Decision Making for Managers MGMT 640 Lecture 1 : Financial Management in Organizations - Key Players, Terms, Structure, and Forms of Business Organizations Learning Objectives 1. Identify forms of business organizations. 2. Describe financial decisions and the role of the financial manager. 3. Identify key players and describe their roles in managing the financial function. 4. Describe the goal of a firm and practices to align the interests of management and shareholders. 5. Explain agency relationships. 6. Discuss the importance of ethics in business. Welcome to the Financial Decision Making for Mangers. In this first lecture, we will learn about how managers make financial decisions on behalf of their companies. With this, we will discuss key players, terms, structure, and different forms of business organizations. Forms of Business Organizations 1 Who are the owners of a business? To answer to that question, one must know how the business is legally organized. There are three main forms of business organizations and several hybrid forms as well. - A Sole Proprietorship is a business owned by one person. There is no legal distinction between the personal and business assets of the sole proprietor, and the sole owner bears unlimited liability for the debts and other obligations of the business. In a sole proprietorship, there is a tax liability on income at the personal income tax rate. - A Partnership consists of two or more owners who have joined together legally to manage the business. There are two types of partnerships: a general partnership and a limited partnership. Partners in a general partnership carry the same basic advantages and disadvantages as a sole proprietorship. A limited partnership can help to limit the liability of the limited partner, but the general partner still bears unlimited liability. In a partnership, there is a tax liability on income at the personal income tax rate. - A Corporation is unique in that it is a separate legal entity that is distinct from its owners, referred to as stockholders or shareholders. The major advantage to organizing as a Corporation is that the owners have limited liability for the debts and obligations of the company. It is also the easies form of business organization for raising capital. The major disadvantage to organizing as a Corporation is double taxation. Taxes are first paid at the corporate level and then again at the personal level when dividends are paid to the shareholders. In addition, corporations are more difficult to form than a sole proprietorship or partnership. - Several hybrid forms of business organizations exist. These hybrids were formed to combine the limited liability aspects of a corporation with the tax advantages offered by a partnership, thereby avoiding double taxation. The Role of the Financial Manager The financial manager is responsible for making decisions that are in the best interest of the firm’s owners. The three key decisions that financial managers make are: the capital budgeting decisions, the financing decisions, and the working capital decisions. Recall that a for-profit business exists to generate cash flow for its owners. The business generates cash flow by selling goods or services that are produced by its productive assets and human capital. After paying operating expenses, creditors, and taxes, any remaining (or residual) cash flow in a profitable 2 business is either reinvested in the business or distributed to the owners as a cash dividend. The financial manager is tasked with making the decision of how surplus cash should be handled. Deciding how surplus cash should be handled is only one aspect of the three fundamental types of decisions faced by financial managers. Determining how to handle surplus cash would fall into the third category: Working Capital Management Decisions, along with other decisions that govern the day-to-day financial matters of the business.  Working capital is the day-to-day management of a firm's short-term assets and liabilities. The purpose is to make sure that there is enough cash to cover operating expenses and an interest is earned on the spare cash. It can be managed through maintaining the optimal level of inventory, keeping track of all the receivables and payables, deciding to whom the firm should extend credit, and making appropriate investments with excess cash. The other two categories of decisions are Capital Budgeting and Financing decisions. Financial managers must make critical decisions on behalf of their company. They must determine which productive assets the firm should buy or invest in. This is known as capital budgeting. This decision is critical as it directly impacts the business’ success or failure. Not only do financial managers need to determine which assets to buy, but they must also determine if the business should finance or purchase these assets.   Financing decisions determine how a firm will raise capital. Examples of financing decisions would be securing a bank loan or the sale of debt in the public capital markets. Capital budgeting involves deciding which productive assets the firm invests in, such as buying a new plant or investing in a renovation of an existing facility. The appropriate goal of financial managers should be to maximize the current value of the firm's stock price. Managers' decisions affect the stock price in many ways as the value of the stock is determined by the future cash flows the firm can generate. Managers can affect the cash flows by, for example, selecting what products or services to produce, what type of assets to purchase, or what advertising campaign to undertake. Financial managers should only select a capital project if the value of the project's future cash flows exceeds the cost of the project. In other words, managers should only take on investments that will increase the firm's value and thus increase the shareholders' wealth. 3 The Goal of the Firm The goal of the firm is to maximize shareholder wealth. In most cases this is equivalent to maximizing the price of the shares of the firm. Note that this is not the same as maximizing profits since maximizing profits can occur while taking on too much risk (which can lower the value of the shareholder investment). Maximizing profits also does not take the timing of the profits into account. Profits, moreover, should not be confused with cash. Maximizing shareholder wealth is also not the same as minimizing risk, which can occur without taking any risks. The value of the company’s stock is impacted by the size, timing, and risk associated with the expected future cash flows. Therefore, financial managers should focus on maximizing the value of the company’s stock. Capital Structure and Financing Basic sources of funds for the firm include debt and equity. Capital structure shows how a company is financed; it is the mix of debt and equity on the liability side of the balance sheet. It is important as it affects the risk and the value of the company. All else being the same, companies with higher debt-toequity proportions are riskier because debt comes with legal obligations to pay periodic payments to creditors and to repay the principal at the end. A firm should undertake a capital project only if the value of the project’s future cash flows exceeds the cost of the project. 4 A profitable firm is able to generate more than enough cash through its operations to cover its operating expenses, taxes, and payments to creditors. Unprofitable firms fail to generate sufficient cash flows, and therefore they may be forced to declare bankruptcy. The firm’s financial management team must assess financial statements such as the balance sheet, which summarizes the company’s assets, liabilities, and shareholders’ equity. An asset is an item of economic value. A liability is a legal debt or obligation. A current liability is a liability that is payable within one year. Key Players and Managing the Financial Function In a large corporation, the financial manager is not a specific position within a company, but rather, the responsibilities of financial management are shared among several positions, both internal and external to the company. Note the various roles in this diagram. All roles shaded purple are members of management and are internal to the company. All roles shaded green are independent of management and are external to the company. Not pictured is the special subcommittee of the Board of Directors called the Audit Committee. The Audit Committee approves the external auditor’s fees and engagement letter and authorizes any changes in external auditors. 5 The most important governing body within an organization is the board of directors. Its main role is to represent the shareholders. The board also hires (and occasionally fires) the CEO and advises him or her on major decisions. The CEO reports to the board of directors. The CFO’s responsibilities center on financial analysis. He or she presents the best options to the CEO. The CFO also oversees the controller, the treasurer, and internal auditors. The controller has specific duties that include preparing financial statements, overseeing the firm’s financial and cost accounting systems, preparing taxes, and working with external auditors to supply accurate data. The treasure collects and disburses cash, invests cash to earn interest, raises capital, and oversees the firm’s pension fund managers (if applicable). The internal auditor performs risk assessment and audits areas of concern. The external auditor performs and independent audit of the firm’s financial statements. The independent CPA firm that performs an audit of a firm ensures that the financial numbers are reasonably accurate, that accounting principles have been adhered to year after year and not in a manner that distorts the firm's performance, and that the accounting principles used are in accordance with generally accepted accounting principles (GAAP). Other Key Players and Definitions Stakeholders are invested in a company’s success for various reasons that may include customer relations, community service/opportunities, supplier relations, employee promotion, and more. Stakeholders may also own stock in the company, but this is not a requirement for the stakeholder. The terms shareholders and stockholders are often used interchangeably. A shareholder owns shares of a for-profit corporation. Shareholders can also be thought of as stakeholders in the firm due to this ownership. The stockholder’s legal liability extends only to the capital contributed or the amount invested. Lenders are also considered stakeholders in a firm. The Internal Revenue Service (IRS) may also be considered a stakeholder in the firm due to the tax revenue that it collects from the firm. 6 Agency Relationships Financial managers are in what is known as an agency relationship. An agency relationship arises whenever one party, called the principal, hires another party, called the agent, to perform some services or to represent the principal’s interest. For large corporations, the ownership of the firm is spread over a huge number of shareholders. In this situation, the owners of the business, that is the shareholders, individually have little control over the agents who they hired as financial managers to act in the best interest of the corporation. Financial managers have access to and control over the corporation’s money. In addition, they make decisions on behalf of the corporation that are supposed to be in the best interest of the company. However, conflict arises when shareholders disagree with decisions of the financial managers. Agency conflict involves separation of ownership and control in large corporations. In some cases, financial managers make decisions that are in their own personal best interests, which creates conflict with the shareholders. This conflict of interest causes an internal cost that is referred to as an Agency Cost. There are specific regulations in place pertaining to boards of directors to reduce agency conflicts. The majority of the board members must be outsiders. A separation of the CEO and chairman of the board positions is recommended. And, the CEO and CFO must certify all financial statements. Agency conflicts can be reduced through the following three mechanisms: management compensation, control of the firm, and the board of directors. One of the best ways to reduce agency conflict is thought to be an effective compensation package. 7 Aligning the Interests of Management and Shareholders Companies and regulators alike have taken steps to mitigate agency costs. If the interests of financial managers and the firm are not aligned, eventually the firm will underperform, causing its stock price to fall below its maximum potential. With an undervalued stock, the firm is now a prime takeover candidate by so-called corporate raiders or other buyers. To help align the interests, a significant portion of financial management’s compensation is usually tied to the firm’s stock price. This creates an incentive for the manager to make decisions that will be in the best interest of the company. If the stock price rises, the manager’s compensation rises as well. The independence of the Board of Directors is extremely important. Regulators believe one of the primary reasons for misalignment between Board Members’ and stockholders’ interests is lack of Board independence. Only when the Board of Directors remains independent of both management, and of the performance of the Company, is it able to perform its oversight role effectively. Finally, the U.S. Congress passed the Sarbanes-Oxley Act of 2002 as well as other regulatory reforms to help ensure management performs its job as an agent appropriately, and does not act in its own best interest. Therefore, an efficient managerial labor market, a well designed management compensation package, and The Sarbanes-Oxley Act of 2002 are mechanisms that help align management interests with those of the company’s shareholders. 8 The Importance of Ethics in Business There are two prominent types of ethical conflicts in business: conflicts of interest and information asymmetry. Even with the U.S. Congress voting to enact the Sarbanes-Oxley Act of 2002 and instituting other regulatory reforms, ethicists argue that laws and market forces are not enough to stop unethical behavior in a company. Historically, despite heavy regulation, the financial sector has had a long and rich history of financial scandals. Ethical conflicts take two main forms: Conflicts of Interest and Information Asymmetry. Conflicts of Interest occur when a conflict arises between a person’s personal or institutional gain and their obligation to serve the interests of another party. Information Asymmetry occurs when one party in a business transaction has information that is unavailable to the other parties in the transaction. One way to resolve a conflict of interest is by complete disclosure. For instance, as long as both parties in a law suit are aware of the fact that they are represented by the same law firm, the disclosure is sufficient. Another way to avoid a conflict of interest is for the law firm to remove itself from serving the interest of one of the parties. This is, for example, the case with accounting firms not being allowed to serve as consultants to companies for which they perform audits. It is paramount that a company promotes an ethical business culture to its employees. This provides the employees with a set of principles and expectations that help them identify moral issues and make ethical judgments without being told what to do. Achieving an ethical business culture should be the goal of all companies to ensure compliance with laws and regulations, integrity, and to avoid the high cost of ethical misjudgments. 9