The Financial Manager and the Firm

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Learning Objectives
1. Identify the key financial decisions facing the
financial manager of any business
2. Identify common forms of business
organization in the United States and their
respective strengths and weaknesses
3. Describe the typical organization of the
financial function in a large corporation

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Learning Objectives
4. Explain why maximizing the value of the firm’s
stock is the appropriate goal for management
5. Discuss how agency conflicts affect the goal of
maximizing stockholder value
6. Explain why ethics is an appropriate topic in the
study of corporate finance

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The Role of the Financial Manager
• Maximize Shareholder Wealth
• Maximizing the price of a firm’s stock will maximize the value of a
firm and the wealth of its shareholders/owners
• Stakeholders
• Managers, employees, suppliers, creditors, and the government

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The Role of the Financial Manager
• It’s All About Cash Flows
• Positive residual cash flow may be paid to firm owners as dividends
or invested in the firm
• The larger the positive residual cash flow, the greater the value of a
firm
• Negative residual cash flow, over the long run, leads to bankruptcy
or closing a business

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Copyright© 2015 John Wiley & Sons, Inc. 6
The Role of the Financial Manager
• Three Fundamental Decisions in Financial Management
• Capital Budgeting: decide which long-term assets to acquire to
maximize net benefits for the firm
• Financing: decide how to pay for short-term and long-term assets
by finding the best combination of short-term debt, long-term debt,
and equity
• Working Capital: decide how to manage short-term resources and
obligations by adjusting current assets and current liabilities to
promote growth in cash flow
• Poor decisions about capital budgeting, financing, or
working capital may lead to bankruptcy or business failure

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Copyright© 2015 John Wiley & Sons, Inc. 8
Forms of Business Organization
• Sole proprietorships
• Partnerships
• Corporations

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Sole Proprietorship
• Owned by a single person who is financially responsible
for the actions and obligations of the business
• Advantages
• Easiest to create and control
• Easiest to dissolve
• Right to all profits
• Disadvantages
• Owner’s personal assets at risk due to unlimited liability for firm
obligations
• Equity only from owner or business profit
• Business income taxes as personal income
• Difficult to transfer ownership

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Partnership
• A business owned by more than one person; one or more
of them financially responsible for the actions and
obligations of the business
• Advantages
• Limited protection of owner’s personal assets
• Owner’s limited liability for firm obligations
• More sources of equity
• More sources of expertise
• Disadvantages
• Shared control
• Shared profit harder to dissolve

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Corporation
• A business owned by more than one person; none of
them financially responsible for the actions and
obligations of the business. The corporation is
responsible for its obligations and actions.
• Advantages
• Protects personal assets
• No shareholder liability for business
• Easiest to change ownership
• Greatest access to sources of funds
• Disadvantages
• Most difficult and expensive to establish
• Dilutes individual control over the firm
• Overall higher taxes on income for shareholders

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Hybrid Forms of Business Organization
• Limited Liability Partnerships (LLPs)
• Limited Liability Companies (LLCs)

• Both combine limited liability with tax advantages of a

partnership

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Managing the Financial Function
• Organizational Structure
• Chief Financial Officer (CFO), responsible for the quality of the
financial reports received by the Chief Executive Officer (CEO)
• Positions Reporting to the CFO
• Treasurer
• Risk Manager
• Internal Auditor
• External Auditor
• Audit Committee
• Compliance and Ethics Director

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Copyright© 2015 John Wiley & Sons,
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The Goal of the Firm
• Why not maximize market share?
• Giving away goods or services for free will maximize a firm’s
market share for a while, but the firm will not be able to pay its bills
and stay in business
• Why not maximize profits?
• Accounting profit differs from economic profit
• Profit earned may not equal cash received
• Maximize the value of the firm’s stock
• Future cash flows are considered
• The timing of future cash flows is considered
• The risks associated with having to wait to for cash flows are
considered
• Can management decisions affect stock prices?

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The Goal of the Firm
• Its All About Cash flow!
• Positive residual cash flow may be paid to firm owners as dividends
or invested in the firm
• The larger the positive residual cash flow, the greater the value of a
firm
• Negative residual cash flow – over the long run - leads to
bankruptcy or closing a business

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Copyright© 2015 John Wiley & Sons,
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Agency Relationship

• An agency relationship is created when the owner (a

principal) of a business hires an employee (an agent)
• The owner surrenders some control over the enterprise
and its resources to the employee
• Separating ownership from control creates the potential
for agency conflicts

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Agency Conflicts
• An agency relationship exists between stockholders
(principals) and the firm’s hired management (agents)
• Ownership and Control
• In large corporations, shared ownership among many shareholders
may result in relatively little control over management
• Shareholders own the corporation, but managers control the firm’s
assets and may use them for their own benefit

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Agency Costs
• Costs that arise from incurring and preventing conflicts of
interest between a firm’s owners and its managers
• These costs may reduce positive residual cash flow, stock
price, and shareholder wealth
• Reduce agency costs by
• Increased oversight
• Align incentives
• Giving agents the right incentives to reduce agency costs
• Managers tend to focus on wealth maximization when their
compensation depends on stock price

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Agency Cost Example
• Today, the firm’s stock trades at $0.95 per share. The
CEO has an option to buy 2.5 million shares from the firm
for $1.15 per share at any time, beginning one year from
today. If the stock price rises to $3.15, the option will be
worth $5 million.

• Option value per share = Stock price – option strike price

($3.15 - $1.15 = $2/share)

• $2/share x 2.5 million = $5 million

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Sarbanes-Oxley and Regulatory Reform
• Better corporate governance reduces agency costs by
requiring
• More effective monitoring of managers’ activities
• Programs that promote appropriate behavior by managers
• Penalties for executives who do not fulfill their fiduciary
responsibilities

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The Importance of Ethics in Business
• What are Ethics?
• Ethics are society’s standards for judging whether an action is right
or wrong
• Business Ethics are society’s standards for acceptable behavior
applied to business and financial markets

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Ethics in Corporate Finance
• Examples of Ethical Conflict in Business
• Agency Cost
• Employee’s unacceptable use of employer’s computer
• Conflict of Interest
• Mortgage contract which a home-buyer is unlikely to fulfill but earns a
mortgage broker more money–
• Information Asymmetry
• Seller knows about prior damage to the vehicle but the potential buyer
does not

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Ethics in Corporate Finance
• Business Behavior
• Regulation and market forces are not enough to maintain integrity
in the marketplace
• Business norms must be based on ethical beliefs, customs, and
practices
• Ethical Behavior
• It is sometimes difficult to judge whether behavior is ethical or not
• Was the manager too careful?
• Did the manager take too much risk?

• Consequences of Unethical Behavior

• Inefficiency in the economy and costs to society
• High legal and social costs
• Problems such as the recent financial crisis in the U.S.
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The Financial System

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Learning Objectives
1. Describe the role of the financial system in the
economy and the two basic ways in which
money flows through the system
2. Discuss direct financing and the important role
that investment banks play in this process
3. Describe the primary, secondary, and money
markets, explaining the special importance of
secondary and money markets to business
organizations

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Learning Objectives
4. Explain what an efficient market is and why
market efficiency is important to financial
managers
5. Explain how financial institutions serve the
needs of consumers and small businesses
6. Compute the nominal and the real rates of
interest, differentiating between them

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Inc.
The Financial System
• Financial markets and institutions
• Financial markets include markets for trading financial assets such
as stocks and bonds
• Financial institutions include banks, credit unions, insurance
companies, and finance companies

• The financial system at work

• The financial system is competitive
• Money is borrowed in small amounts and loaned in large amounts
• The system directs money to the best investment opportunities in
the economy
• Lenders earn profit from the spread between lending and borrowing
rates
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The Financial System
• How Funds Flow through the Financial System
• The primary function of a financial system is to efficiently transfer
funds from lender-savers to borrower-spenders
• Basic mechanisms by which funds are transferred in the
financial system
• Directly through financial markets
• Indirectly through financial institutions

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Copyright© 2015 John Wiley & Sons,
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Direct Financing
• Direct transfer of funds
• Lender-saver contracts with a borrower-spender
• Minimum transaction $1 million
• Investment banks and money center banks help with origination,
underwriting and distribution of new debt and equity
• Underwriting is a service to assist firms in selling their debt or equity
securities in a direct financing market

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Types of Financial Markets
• Primary and Secondary Markets
• Exchanges and Over-the-Counter Markets
• Money and Capital Markets

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Wholesale and Retail Markets
• Primary Market
• Wholesale market where firms’ new securities are issued and sold
for the first time
• Secondary Market
• Retail market where previously issued securities are resold (traded)

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Marketability and Liquidity
• Marketability: ease with which a seller or buyer for an
asset can be found
• Liquidity: ease with which an asset can be converted into
cash without loss of value
• Financial markets increase marketability and liquidity of
securities
• Financial markets lower the costs of making transactions
and make participants more willing and able to pay higher
prices
• A company like Scottrade or E-trade makes it easy for us to buy a
share of Exxon or a bond from Coca-Cola

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Brokers and Dealers
• A broker brings a seller and a buyer together but does
not buy or sell in the transaction
• The broker does not take on risk
• A dealer participates in trades as a buyer or seller using
her own inventory of securities
• The dealer takes on risk

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Exchanges & Over-the-Counter Markets
• Exchange: location where sellers and buyers meet to
conduct transactions
• New York Stock Exchange (NYSE)
• Chicago Board Options Exchange (CBOE)
• Over-the-Counter Market: dealers conduct transactions
over the phone or via computer
• National Association of Securities Dealers Automated Quotations
(NASDAQ)

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Money and Capital Markets
• Money Market: market for low-risk securities with
maturities of less than one year
• Treasury Bills (T-Bills)
• Commercial Paper
• Capital Market: market for securities with maturities longer
than one year
• Bonds
• Common stock

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Indirect Financing
• Institutions, such as banks and insurance companies, are
both borrowers and savers
• An institution borrows money from a saver, lends money to a
borrower, and must repay funds to the saver – whether or not it is
repaid by the borrower

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Financial Institutions and Their Services
• Financial Institutions:
• Provide lending and borrowing opportunities at the retail level for
small customers and wholesale level for large customers
• Efficiently collect funds in small amounts and lend them in larger
amounts
• Tailor loan amounts and contract terms to fit the needs of
consumers, corporations, and small businesses

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The Determinants of Interest Rate Levels
• The Real Rate of Interest
• Loan Contracts and Inflation
• The Fisher Equation and Inflation
• Cyclical and Long-Term Trends in Interest Rates

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Interest Rates
• The interest rate is the fee for borrowing money
expressed as a percentage of a loan
• The real rate of interest
• The interest rate that would exist in the absence of
inflation/deflation
• Determined by the expected return on productive assets and time
preference for consumption
• The nominal rate of interest
• The interest rate adjust for inflation/deflation

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Equilibrium Rate of Interest
• The equilibrium rate of interest is a function of supply and
demand
• Savers supply more funds at higher rates
• Borrowers demand less at higher rates
• Equilibrium is the rate at which the quantity of funds supplied
equals the quantity of funds demanded

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Inflation and Loan Contracts
• Lenders want the interest rates in loan contracts to
include compensation for the inflation predicted to occur
over the life of the contract
• Compensation for expected inflation adjusts loan rates to
offset the higher prices for goods and services expected
to exist when a loan is repaid and a lender spends the
money

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Fisher Equation & Nominal Interest Rate

The Fisher Equation

𝑖 = 𝑟 + ∆𝑃𝑒

Where:
𝑖 = nominal interest rate (also referred to as the quoted rate)
𝑟 = real rate of interest (you should be most concerned about
this number)
∆𝑃𝑒 = expected annualized price-level change

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Fisher Equation & Nominal Interest Rate

Simplified Fisher Equation Example:

If the real rate is 4% and the expected inflation rate is 10%,

what is the approximate expected nominal rate?

𝑖 = 𝑟 + ∆𝑃𝑒
𝑖 = 0.04 + 0.10
𝑖 = 0.14 𝑜𝑟 14%

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Cyclical & Long-Term Interest Rate Levels
• Interest rates tend to rise and fall with changes in the rate
of inflation
• Rates tend to rise when the growth rate of the economy
increases and tend to fall when the growth rate of the
economy slows
• Interest Rate, Business Cycle & Inflation
• Interest rates tend to follow the business cycle
• Interest rates tend to increase during an economic expansion
• Interest rates tend to decrease during an economic contraction

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