CHAPTER 1 An Introduction to Financial Management

                                                                                                                                                                                                                

CHAPTER 1

An Introduction to Financial

Management

                                                                                                                                                                                                               

CHAPTER ORIENTATION

This chapter lays a foundation for what will follow. First, it focuses on the goal of the firm, followed by a review of the legal forms of business organization. Ten principles that form the foundations of financial management then follow.

CHAPTER OUTLINE

I.          Goal of the firm

A.        In this book we will designate maximization of shareholder wealth, by which we mean maximization of the total market value of the firm's common stock, to be the goal of the firm. To understand this goal and its inclusive nature it is first necessary to understand the difficulties involved with the frequently suggested goal of profit maximization.

B.        While the goal of profit maximization stresses the efficient use of capital resources, it assumes away many of the complexities of the real world and for this reason is unacceptable.

1.         One of the major criticisms of profit maximization is that it assumes away uncertainty of returns. That is, projects are compared by examining their expected values or weighted average profit.

2.         Profit maximization is also criticized because it assumes away timing differences of returns.

C.         Profit maximization is unacceptable and a more realistic goal is needed.

II.        Maximization of shareholder wealth

A.        We have chosen the goal of shareholder wealth maximization because the effects of all financial decisions are included in this goal.

B.        In order to employ this goal we need not consider every price change to be a market interpretation of the worth of our decisions. What we do focus on is the effect that our decision should have on the stock price if everything were held constant.

C.        The agency problem is a result of the separation between the decision makers and the owners of the firm. As a result managers may make decisions that are not in line with the goal of maximization of shareholder wealth.

III.       Legal forms of business organization

A.        The significance of different legal forms

1.         The predominant form of business organization in the United States in pure numbers is the sole proprietorship.

B.        Sole proprietorship: A business owned by a single person and that has a minimum amount of legal structure.

1.         Advantages

a.         Easily established with few complications

b.         Minimal organizational costs

c.         Does not have to share profits or control with others

2.         Disadvantages

a.         Unlimited liability for the owner

b.         Owner must absorb all losses

c.         Equity capital limited to the owner's personal investment

d.         Business terminates immediately upon death of owner

C.        Partnership:  An association of two or more individuals coming together as co-owners to operate a business for profit.

1.         Two types of partnerships

a.          General partnership:  Relationship between partners is dictated by the partnership agreement.

l.          Advantages

a.         Minimal organizational requirements

b.         Negligible government regulations

2.         Disadvantages

a.         All partners have unlimited liability

b.         Difficult to raise large amounts of capital

c.         Partnership dissolved by the death or withdrawal of general partner

b.         Limited partnership

l.          Advantages

a.         For the limited partners, liability limited to the amount of capital invested in the company

b.         Withdrawal or death of a limited partner does not affect continuity of the business

c.         Stronger inducement in raising capital

2.         Disadvantages

a.         There must be at least one general partner who has unlimited liability in the partnership

b.         Names of limited partners may not appear in the name of the firm

c.         Limited partners may not participate in the management of the business

d.         More expensive to organize than general partnership, as a written agreement is mandatory

2.         There is also a Limited Liability Company (LLC) form of business.  This is a cross between a partnership and a corporation.  It retains limited liability for its owners, but is run and taxed like a partnership.

D.        The corporation: An "impersonal" legal entity having the power to purchase, sell, and own assets and to incur liabilities while existing separately and apart from its owners.

1.         Ownership is evidenced by shares of stock

2.         Advantages

a.         Limited liability of owners

b.         Ease of transferability of ownership, i.e., by the sale of one's shares of stock

c.         The death of an owner does not result in the discontinuity of the firm's life

d.         Ability to raise large amounts of capital is increased

3.         Disadvantages

a.          Most difficult and expensive form of business to establish

b.         Control of corporation not guaranteed by partial ownership of stock

IV.       The Corporation and the Financial Markets: The Interactions

A.                The popularity of the corporation stems from the ease in raising capital that it provides.

1.                  Initially, the corporation raises funds in the financial markets by selling securities.

2.                  The corporation then invests this cash in return generating assets.

3.                  The cash flow from those assets is either reinvested in the corporation, given back to the investors in the form of dividends or interest payments, or used to repurchase stock which should cause the stock price to rise, or given to the government in the form of taxes.

B.                 A primary market is a market in which new, as opposed to previously issued, securities are traded.

C.                 An initial public offering (IPO) is the first time a company’s stock is sold to the public.

D.                A seasoned new issue refers to a stock offering by a company that already has common stock traded.

E.                 The secondary market is the market in which stock previously issued by the firm trades.

V.        Ten Principles that form the foundation of financial management.

A.        Principle 1: The risk-return tradeoff - we won't take additional risk unless we expect to be compensated with additional return.

1.         Almost all financial decisions involve some sort of risk-return tradeoff.

B.        Principle 2: The time value of money - a dollar received today is worth more than a dollar received in the future.

C.        Principle 3: Cash -- Not Profits -- is King. In measuring value we will use cash flows rather than accounting profits because it is only cash flows that the firm receives and is able to reinvest.

D.        Principle 4: Incremental cash flows - it's only what changes that count. In making business decisions we will only concern ourselves with what happens as a result of that decision.

E.         Principle 5: The curse of competitive markets - why it's hard to find exceptionally profitable projects. In competitive markets, extremely large profits cannot exist for very long because of competition moving in to exploit those large profits. As a result, profitable projects can only be found if the market is made less competitive, either through product differentiation or by achieving a cost advantage.

F.         Principle 6: Efficient Capital Markets - The markets are quick and the prices are right.

G.        Principle 7: The agency problem - managers won't work for the owners unless it's in their best interest. The agency problem is a result of the separation between the decision makers and the owners of the firm. As a result managers may make decisions that are not in line with the goal of maximization of shareholder wealth.

H.        Principle 8: Taxes bias business decisions.

I.          Principle 9: All risk is not equal since some risk can be diversified away and some cannot.  The process of diversification can reduce risk, and as a result, measuring a project’s or an asset's risk is very difficult.

J.          Principle 10: Ethical behavior is doing the right thing, and ethical dilemmas are everywhere in finance. Ethical behavior is important in financial management, just as it is important in everything we do.  Unfortunately, precisely how we define what is and what is not ethical behavior is sometimes difficult.  Nevertheless, we should not give up the quest.

ANSWERS TO

END-OF-CHAPTER QUESTIONS

1-1.      The goal of profit maximization is too simplistic in that it assumes away the problems of uncertainty of returns and the timing of returns.  Rather than use this goal, we have chosen maximization of shareholders' wealth—that is, maximization of the market value of the firm's common stock—because the effects of all financial decisions are included.  The shareholders react to poor investment or dividend decisions by causing the total value of the firm's stock to fall and react to good decisions by pushing the price of the stock upward.  In this way all financial decisions are evaluated, and all financial decisions affect shareholder wealth. 

1-2.      The major difference between the profit maximization goal and the goal of shareholder wealth maximization is that the latter goal deals with all the complexities of the operating environment, while the profit maximization goal does not.  The major factors assumed away by the profit maximization goal are uncertainty and the timing of the returns.

1-3.      The goal of shareholder wealth maximization must be looked at as a long-run goal.  As such, the public image of the firm may be of concern inasmuch as it may affect sales and legislation.  Thus, while these actions may not directly result in increased profits, they may affect consumers' and legislators' attitudes.

1-4.      Almost all financial decisions involve some sort of risk-return tradeoff.  The more risk the firm is willing to accept, the higher the expected return for the given course of action.  For example, in the area of working capital management, the less inventory held, the higher the expected return, but also the greater the risk of running out of inventory.  While one manager might accept a given level of risk, another more risk-averse manager may not accept that level of risk.  This does not mean that one manager is correct and one is not, only that not all managers will view the risk-return trade off in the same manner. 

1-5.      (a)        A sole proprietorship is a business owned by a single individual who maintains complete title to the assets, but who is also personally liable for all indebtedness incurred.

(b)        A partnership is an association of two or more individuals coming together as co-owners for the purpose of operating a business for profit.  The partnership is equivalent to the sole proprietorship, except that the partnership has multiple owners.

(c).       A corporation is a legal entity functioning separate and apart from its owners.  It can individually sue and be sued, purchase, sell, or own property, and be subject to criminal punishment for crimes.

1-6.      (a)        The sole proprietor maintains title to the firm's assets, has unlimited liability, is entitled to the profits from the business, but must also absorb any losses realized.  This form of business is easily initiated.  Termination of the business comes by the owner discontinuing the business or upon his death.

(b)        In a partnership, all general partners have unlimited liability.  Each partner is liable for the actions of the other partners.  The partnership agreement dictates the basic relationships among the partners within the firm.  As with the sole proprietorship, the partnership is terminated upon the desires of any partner within the organization, or upon a partner's death.  Under certain conditions a partner's liability may be restricted to the amount of capital invested in the partnership.  However, at least one general partner must remain in the association for whom the privilege of limited liability does not apply.

(c)        The corporation is legally separate from its owners.  Ownership of the corporation is determined by the number of shares of common stock owned by an individual.  Since the shares are transferable, the ownership in a corporation may be easily transferred.  Investors' liability is limited to the amount of their investment.  The life of the corporation is not dependent upon the status of the investors.  The death or withdrawal of an investor does not disrupt the corporate life.  However, the cost of forming a corporation is more expensive than a proprietorship or partnership.

1-7.      (a)        Organizational requirements and costs favor the sole proprietorship or possibly the general partnership depending upon the approach taken in forming the partnership.

(b)        The corporation minimizes the liability of the owners.  Also, the limited partnership permits some of the partners the privilege of limited liability.

(c)        The corporation is definitely the most favorable form of business because it provides the continuity of the business regardless of an owner's withdrawal or death.

(d)       If ease of ownership transferability is desired, the corporation is best.  However, because of certain circumstances the owners may prefer that ownership not be easily transferred, in which case the partnership would be the most desirable. 

(e)        The sole proprietor is able to maintain complete and ultimate control and minimize regulations.

(f)        The corporation is the strongest form of legal entity in terms of the ease of raising capital from external investors.

(g)        In regard to income taxes, it is difficult to determine which form of business is the most advantageous.  Such a selection is dependent upon individual circumstances.

SOLUTION TO INTEGRATIVE PROBLEM

1.         The goal of profit maximization is too simplistic in that it assumes away the problems of uncertainty of returns and the timing of returns.  Rather than use this goal, we have chosen maximization of shareholders' wealth—that is, maximization of the market value of the firm's common stock—because the effects of all financial decisions are included.  The shareholders react to poor investment or dividend decisions by causing the total value of the firm's stock to fall and react to good decisions by pushing the price of the stock upward.  In this way all financial decisions are evaluated, and all financial decisions affect shareholder wealth. 

2.         Simply put, investors won't put their money in risky investments unless they are compensated for taking on that additional risk.  In effect, the return investors expect is composed of two parts.  First, they receive a return for delaying consumption which must be greater than the anticipated rate of inflation.  Second, they receive a return for taking on added risk.  Otherwise, both risky and safe investments would have the same expected return associated with them and no one would take on the risky investments.

3.         The firm receives cash flows and is able to reinvest them rather than accounting profits.  In effect, accounting profits are shown when they are earned rather than when the money is actually in hand.  Unfortunately, a firm's accounting profits and cash flows may not be timed to occur together.  For example, capital expenses, such as the purchase of a new plant or piece of equipment, are depreciated over several years, with the annual depreciation subtracted from profits.  However, the cash flow associated with these expenses generally occurs immediately.  It is the cash inflows that can be reinvested and cash outflows that involve paying out money.  Therefore, cash flows correctly reflect the true timing of the benefits and costs.

4.         In an efficient market, information is impounded into security prices with such speed that there are no opportunities for investors to profit from publicly available information.  Actually, what types of information are immediately reflected in security prices and how quickly that information is reflected determine how efficient the market actually is.  The implications for us are, first, that stock prices reflect all publicly available information regarding the value of the company.  This means we can implement our goal of maximization of shareholder wealth by focusing on the effect each decision should have on the stock price all else held constant.  It also means that earnings manipulations through accounting changes should not result in price changes.  In effect our preoccupation with cash flows is validated.

5.         The agency problem is the result of the separation of management and the ownership of the firm.  As a result managers may make decisions that are not in line with the goal of maximization of shareholder wealth.  To control this problem we monitor managers and try to align the interests of shareholders and managers.  The interests of shareholders and managers can be aligned by setting up stock options, bonuses, and perquisites that are directly tied to how closely management decisions coincide with the interest of shareholders.

6.         Ethical errors are not forgiven in the business world.  Business interaction is based upon trust and there is no way that trust can be eliminated quicker than through an ethical violation.  The fall of Arthur Andersen, Ivan Boesky and Drexel, Burnham, Lambert and the near collapse of Salomon Brothers illustrates this fact.  As a result acting in an ethical manner is not only morally correct, but it is congruent with our goal of maximization of shareholder wealth.

7.         (1)        A sole proprietorship is a business owned by a single individual who maintains complete title to the assets, but who is also personally liable for all indebtedness incurred.

(2)        A partnership is an association of two or more individuals coming together as co-owners for the purpose of operating a business for profit.  The partnership is equivalent to the sole proprietorship, except that the partnership has multiple owners.

(3).       A corporation is a legal entity functioning separate and apart from its owners.  It can individually sue and be sued, purchase, sell, or own property, and be subject to criminal punishment for crimes.

SOLUTION TO CASE

LIVING AND DYING WITH ASBESTOS

With ethics cases there are no right or wrong answers—just opinions.  Try to bring out as many opinions as possible without being judgmental or allowing other students to be judgmental.  Also, it is effective to try to see if the students feel there are any possible parallels between what has happened in this case and the tobacco industry.