Ppt chapter 01 Business Finance by Lets Get Dressed

Chapter 1 Goals and Governance of the Corporation p

Topics Covered 1.1 1.2 1.3 1.4 1.5 1.6 1 6 1.7 1.8 1.9

Investment and Financing Decisions What is a Corporation? Who Is the Financial Manager? Goals of the Corporation Agency Problems, Executive Compensation, and Corporate Governance The Ethics of Maximizing Value The Ethics of Maximizing Value Careers in Finance A Preview of Coming Attractions Snippets of Financial History 1- 2

Investment and Financing Decisions  Capital Budgeting Decision – Decision to invest in tangible or Decision to invest in tangible or intangible assets – What long‐term investments or projects should the business take on?  …also called …also called – the Investment Decision – the Capital Expenditure (CAPEX) decision 1- 3

Investment and Financing Decisions  “Capital Budgeting” TANGIBLE ASSETS

INTANGIBLE ASSETS

Southwest Airlines Purchase new planes

GlaxoSmithKline R&D expenditures

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“Capital Budgeting”

Tangible Assets

Intangible Assets

Toyota Plants

Gillette’s Fusion Razor

@ $3 billion new debt

@ $200 million

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 If a project’s value is greater than its required investment, then the project is attractive financially.  An effective financial manager guides his or her firm to invest in projects that add more value than the investment required.  In other words, the financial manager helps I th d th fi i l h l the firm to invest in projects that are worth more than they cost. 1-6

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Investment and Financing Decisions  Financing Decision – Decision on the sources and amounts of D ii h d f financing  Capital Structure – The mix of long‐term debt and equity financing  How should we pay for our assets?  Should we use debt or equity? 1- 7

Investment and Financing Decisions

ASSETS

FIRM

Investment Decision Debt

Equity q y

Financing Decision

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Investment and Financing Decisions The Investment Decision – When firm invests, it acquires Real Assets, and use them to produce the firms’ products and services. The Financing Decision – The firm finances its investment in real assets by issuing Financial Assets to investors.

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Investment and Financing Decisions  Real Assets – Assets used to produce goods and services A t dt d d d i

 Financial Assets – Financial claims to the income generated by the firm’s real assets

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Investment and Financing Decisions  Are the following capital budgeting or financing decisions? – Intel decides to spend $1 billion to develop a new microprocessor – Volkswagen borrows 350 million euros (€350 million) from Deutsche Bank – Royal Dutch Shell constructs a pipeline to bring natural gas onshore from a production platform in Australia gas onshore from a production platform in Australia – Avon spends €200 million to launch a new range of cosmetics in European markets – Pfizer issues new shares to buy a small biotech company 1- 11

Number of Firms in the U.S.

Size of Payroll (000s) Corporation

1,011,973 1,292,081

$1,068,232,095

S‐Corporation

622,908 Partnership

$2,808,013,079

2,584,427 Sole Sole Proprietorship

$479,673,700

$149,121,474

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Organizing a Business  Types of Business Organizations 

Sole Proprietorships 

You own the assets personally and run the business by yourself.

Partnerships  Corporations  Limited Liability Options (P.9) 

• Limited Liability Partnerships y p • Limited Liability Corporations • Professional Corporations

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What is a Corporation?  Corporation A business organized as a separate legal entity owned by stockholders.  Limited Liability  The owners of a corporation are not personally liable for its obligations 

 Types of Corporations Public Companies  Whose shares are available for purchase by any investor.  Private Corporations Whose shares are not available for purchase by any investor. 1-14 

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What is a Corporation?  S Corporation  An S corporation is a special structure of business ownership by which the business is able to avoid double taxation because it is not required to pay corporate income tax on the profits of the company. All profits/losses are passed on directly to the shareholders of the company. The shareholders file individual tax returns and pay income tax on whatever share of profits they receive from the business.  By electing to become an S corporation, a small business can avail the legal advantages available to businesses with a corporate structure as well as the tax advantages available to partnership firms.  The business however must conform to certain set criteria before it can be accorded an S corporation status.

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What Is a Corporation?

Sole Proprietorship

Partnership

Corporation

Who owns the business?

The manager

Partners

Stockholders

Are managers and owners separate?

Usually

What is the owner’s liability?

Unlimited

Limited

Are the owner and business taxed separately?

Yes

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What Is a Corporation? Sole Proprietorships

Unlimited Liability Personal tax on profits

Partnerships

Limited Liability Corporations

Corporate tax on profits + Personal tax on dividends

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Sole Proprietorship  Advantages Easiest to start  Least regulated  Single owner keeps all the profits  Taxed once as personal income 

 Disadvantages Limited to life of owner  Equity capital limited to owner’s personal wealth  Unlimited liability  Difficult to sell ownership interest 

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Partnership  Advantages

 Disadvantages

Two or more owners  More capital available  Relatively easy to start  Income taxed once as personal income 

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Unlimited liabilityy • General partnership • Limited partnership

Partnership dissolves when one partner dies or wishes to sell  Difficult to transfer ownership 

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Corporation  Advantages Limited liabilityy  Unlimited life 

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(Hudson’s Bay Company was formed in 1670 and is still one of Canada’s leading retail chains).

Separation of ownership and management g  Transfer of ownership is easy  Easier to raise capital 

 Disadvantages Separation p of ownership and management  Double taxation (income taxed at the corporate rate and then dividends taxed at the personal rate) 

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S-Corporation  Advantages No Corporate p Tax  Reduce Taxable Gains  Write off Start-up Losses  Liability Protection 

 Disadvantages Limited to 35 shareholders  Can only use domestic capitalization  Shareholders pay taxes on all profits in the year earned,, whether or not they are distributed. 

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Who Is the Financial Manager? Most large companies have 3 top‐level financial managers:

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Who Is the Financial Manager?  Chief Financial Officer (CFO) – Supervises all financial functions and sets p overall financial strategy  Treasurer – Responsible for financing, cash management, and relationships with banks and other financial institutions  Controller – Responsible for budgeting, accounting, and taxes 1- 23

Role of the Financial Manager (2)

(1)

Financial Financial Manager

Firm’s Fi ’ Operations (3)

(4) Investors (4b)

Real assets

Financial assets

1. Cash raised from investors 2. Cash invested in firm 3. Cash generated by operations 4A. Cash reinvested in the firm 4B. Cash returned to investors 1- 24

The Role of The Financial Manager  The financial manager stands between the firm and outside investors. Help manage the firms’ operations by making good investment decisions  Deal with investors, such as shareholders, banks, financial institutions and financial markets. 

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Goals of the Corporation  Shareholders desire wealth maximization Profit maximization  Profit maximization – Maximize profits? Which year’s profits? – Earning manipulation  Opportunity cost of capital – The minimum acceptable rate of return on The minimum acceptable rate of return on capital investment is set by the investment opportunities available to shareholders in financial markets 1- 26

Goals of the Corporation The Investment Trade‐Off

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 It is called the opportunity cost of capital because it depends on the alternative investment opportunities available to shareholders in the l bl h h ld h financial markets. Whenever a corporation invests cash in a new project, its shareholders lose the opportunity to invest the cash on their own.  Corporation increase value by accepting all C ti i l b ti ll investment projects that earn more than the opportunity cost of capital.

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The Agency Problem  Agency relationship Principal p hires an agent g to represent p his/her interests  Stockholders (principals) hire managers (agents) to run the company 

 Agency problem 

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Conflict of interest between principal and agent

Agency cost Value lost from agency problems or from the cost of mitigating agency problems

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Agency Problem – Do managers maximize shareholder wealth or manager wealth? – Agency Problems Agency Problems • Managers are agents for stockholders, but the managers may act in their own interests rather than maximizing value Shareholders vs. Stakeholders

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 Stakeholder – Anyone with a financial interest in the firm. Each as a stake in the firm, but their interests may not coincide. – Which includes the management, workforce, lenders, shareholders, and the government, etc. – Agency problems arise whenever the stakeholders’ interests do not coincide

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Agency Problem Ownership vs. Management Difference in Information    

Stock prices vs. returns Dilution of ownership Dividend policy Financing decisions

Different Objectives  Managers vs. stockholders  Top managers vs. lower managers  Stockholders vs. banks and lenders

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Agency Problem  Corporate governance – The laws, regulations, institutions, and The laws, regulations, institutions, and corporate practices that protect shareholders and other investors

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Agency Problem Elements of good corporate governance 1. Legal requirements Legal requirements 2. Board of directors 3. Activist shareholders 4. Takeovers 5 Information for shareholders 5. Information for shareholders

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Agency Problem Solutions Compensation plans Board of Directors SOX Act requires corporations to place more independent directors on the board. Blockholders Institutional shareholders have become more active in monitoring firm performance and proposing changes to corporate governance. 1-35

CEO Compensation and Agency Problem

Eliezer M.Fich, Laura T.Starks, Adam S.Yore Journal of Financial Journal of Financial Economics, 114(2014)471–492

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Abstract   

Sample of 11,815 firm‐year observations We find that changes in CEO compensation are significantly related to the CEOs' deal‐making activities. Greater CEO pay changes are associated with specific deals, thus supporting the hypothesis that boards consider CEO deal‐making in their compensation decisions.

Whether the pay raises to deal‐making CEOs are linked to firm performance. • Pay‐for‐performance sensitivity (PPS) analyses :compensation for deal‐making CEOs is markedly sensitive to good performance but apparently insensitive to bad y g p pp y performance. • Deal making can insulate CEOs from the risk of being fired for poor performance, some CEOs receive pay raises for doing deals irrespective of whether the transactions are expected to improve firm value.

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Agency Problem Solutions Takeovers Poorly performing companies are more likely to be taken o er b another firm The old management taken over by another firm. The old management team is then likely to find itself out on the street. Specialist Monitoring Security Analysts: advise investors to buy, hold, or sell. Bankers: keep an eagle eye on the progress of firms receiving their loans. Legal and Regulatory Requirements SEC sets accounting and reporting standards Sarbanes‐Oxley Act (SOX) 1-38

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Agency Problem Solutions  Agency problems are mitigated in practice in several ways: legal and regulatory standards; compensation plans that tie the fortunes of the managers to the fortunes of the firm; monitoring by lenders, stock market analysts, and investors; and ultimately the threat that poorly performing managers will be fired. poorly performing managers will be fired.

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Ethics of Maximizing Value  “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self‐love, and never talk to them of our own necessities but of their advantages.” – Adam Smith, 1776  Does value maximization justify unethical behavior? – Charles Ponzi – Bernard Madoff – Tyco

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Homework #1 Does value maximization justify unethical behavior? Recent examples: – Enron – WorldCom – Bernard Madoff’s Ponzi scheme – Goldman Sachs – Tyco T – The collapse of Baring Bank – the Nick Leeson Story – Putnam Investment – market timing scandal 1-41

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Snippets of Financial History Date Unknown 1800 b.c. 1000 b.c. 15th C 15th C 1650 17th C 17th C 1720 1792 1929 1960 1971 1972 1986 1988 1993 1780 & 1997 1993 1999 2002 2007‐2009 2011

Activity Compound growth Interest rates Options International banking International banking Futures Stock corporations Currency New issue speculation NYSE formed Stock market crash Eurodollar market Corporate bankruptcies Financial futures Capital investment decisions Mergers Inflation Inflation securities Controlling risk The Euro Financial scandals Subprime mortgages Sovereign debt defaults

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