What Should a Financial Manager Try to Maximize?
Maximize Profit? |
Many believe managers job |
Take only actions to increase revenues |
Maximise amount earned on each share |
Earnings per share (EPS) = earnings of common stockholders divided by number of shares of common stock outstanding |
Flaws in approach: |
- Figures for earnings historical, reflect past performance |
- Do not focus on what is happening now / in future |
- Timing may be ignored. Large profits that pay off many years in future may be less valuable than smaller profits received next year |
Maximize Shareholder Wealth? |
Current theory |
Measured by market price of firm's stock. |
Stock price reflects timing, magnitude, and risk of cash flows that investors expect a firm to generate over time. |
Take only actions that increase value of firms future cash flows. |
Shareholders are residual claimants. Can claim only on cash flows that remain after employees, suppliers, creditors, governments, and other stakeholders are paid in full |
There is a risk shareholders receive nothing |
Shareholders bear most of risk of running firm |
This is why firms operate to maximize shareholder wealth. The benefit to all is that it gives investors incentive to accept the risks necessary to buy stock and provide funds necessary for a business to thrive. |
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Focus on other Stakeholders? |
Many firms also focus on employees, customers, tax authorities, and communities |
These firms consciously avoid actions that harm stakeholders by transferring their wealth to shareholders. |
Not to maximize others interests but to preserve those interests. |
Benefits |
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Keeping stakeholders happy has long-term benefit to share-holders |
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Helps minimise employee turnover, conflicts, and litigation. |
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Usually actually leads to maximizing shareholder wealth |
Conflicts |
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Between these two objectives inevitably arises. |
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Firms is ultimately run to benefit stockholders. |
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Corporations are generally expected to be socially responsible |
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But rarely required by law to be in US and AUS |
Finance skills
All finance jobs require: |
Good written and verbal communication skills |
Ability to work in teams |
Proficiency with computers and the Internet |
Many finance jobs require: |
In-depth knowledge of international business |
Finance career opportunities: |
Corporate finance |
Commercial banking |
Investment banking |
Money management |
Consulting |
Consulting
Analyse firms business processes and strategies |
Recommend how practices should change to make firms more competitive |
Implement recommendations |
Spend up to 200+ days yearly on the road |
Money Management
Industry |
Investment advisory firms |
Mutual fund companies |
Pension fund managers |
Trust departments of commercial banks |
Investment arms of insurance companies |
Any person or institution that acts as a fiduciary—someone who invests and manages money on someone else's behalf |
Trends |
Baby Boomers investing large sums in preparation for retirement - demand for pofessional money managers surged |
Australian superanuation legislation passed in 1992 requring all employees to be members of a superfund - that industry grew massively |
Institutionalisation of investment, means today institutional investors dominate the markets |
Corporate Finance
The duties of the financial manager in a business / Not for profit / Corporation |
Tasks include: |
Budgeting |
Financial forecasting |
Cash management |
Credit administration |
Investment analysis |
Funds procurement |
Modern business changes: |
Increases in regulatory environments have increased the importance and complexity of the financial manager's duties |
Globalisation has increased need to assess and manage the risks associated with volatile exchange rates and rapidly changing political environments. |
Finance Function: Financial Management
Managing firms operating cash flows as efficiently and profitably as possible. |
Capital structure decision finding right mix of debt and equity securities to maximise firms overall market value. |
Managing working capital |
Ensure enough working capital on hand for day-to-day operations |
Obtaining seasonal financing |
Building up enough inventories to meet customer needs |
Paying suppliers |
Collecting from customers |
Investing surplus cash |
Maintaining adequate cash balances |
Skills: |
Technical and analytical skills |
People skills - relationships with customers, suppliers, lenders, and others |
Finance function: Risk Management
Identifies, measures, and manages many types of risk exposures including: |
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Predictable business risks-losses such as adverse interest rate movement commodity price changes, and currency value fluctuations. |
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Unpredictable 'acts of nature' |
Risk management techniques |
Insurance products (fire, flood, theft, injury) |
Self-insurance to manage exposures |
Quantify the sources and magnitudes of risk exposure and decide whether to accept them or to manage them. |
Diversification (contract with several suppliers, even if it means purchasing the input at slightly more than the lowest possible price) |
Modern risk management |
Market-driven risks interest rates, commodity prices, and currency values. |
Financial instruments called derivatives (derive their value from other, underlying assets) have been developed for use in hedging (offsetting) for more threatening market risks. |
Australian legal forms of business
Sole proprietorships |
General Partnerships |
Limited Partnerships |
Proprietry Limited Company |
Company |
General Partnerships
Proprietorship between 2+ owners |
No distinction between owners and business |
Joint and several liability |
Unless specified all debts and equity, profits, are split evenly |
Decision making ability is split evenly |
Income taxed at personal level |
Limited life - cease when one owner dies or retires |
Limited access to capital - Reinvesting profits, personal loans |
Unlimited personal liability - Personally liable owner for all debts, including lawsuits |
Proprietry Limited Company
Business seperate entity to owner |
Creates roles of employee, director, shareholder |
Regulated under the corporations act 2001 |
Establishment and ongoing costs to manage can be high |
Suited to Medium and Large businesses |
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Role of finance manager
constantly apply financial tools to solve real business problems |
Ensure business managers take only actions where benefits exceed costs |
Interact with experts in a wide range of disciplines |
Study economics of a market |
Develop pricing strategy |
Negotiate licensing agreements |
Work with authorities to ensure compliance |
Advise business managers and professionals |
Work with accounting and systems staff to develop systems |
Managing cash flows |
Assessment and funding of research |
Aid business in accumulating the capital needed to fund projects |
The skills and knowledge needed to achieve corporate business objectives are the same as those needed to be a successful entrepreneur, to manage family businesses, or to run a nonprofit organization. Successful financial managers must be able to creatively manage both people and money.
Financial intermediary
Companies can obtain debt capital by selling securities either directly to investors or through financial intermediaries. |
Financial intermediary |
Institution that raises capital by issuing liabilities against itself |
Uses the capital raised to make loans to corporations and individuals |
Borrowers have no direct contact with those who funded the loan |
Financial intermediaries include: |
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Insurance companies |
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Savings and loan institutions |
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Credit unions |
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Commercial banks |
Modern financial intermediary services |
Loans to corporations and individuals |
Allow companies and individuals to place their money in demand deposits |
Backbone of the payments system: |
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Collect payment on transfers sent to corporate customers |
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Make payment on the transfers by their customers to other parties |
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Provide information-processing services to SME businesses |
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Handle large-volume transactions such as payroll |
These organisations issue liabilities such as demand deposits (checking accounts) to companies and individuals and then loan these assets to corporations, governments, and households
Investment Banking
Interesting nature of work |
Three main types of activities: |
Helping corporate customers obtain funding by selling securities such as stocks and bonds to investors |
Providing advice to corporate clients on strategic transactions such as mergers and acquisitions |
Trading debt and equity securities for customers or for the firm's own account |
Profitability |
High income potential |
Extraordinarily high since the early 1990s |
Highly volatile industry |
Entry-level salary range $50,000 to more than $80,000, plus bonuses |
Incomes often rise rapidly |
Industry |
Dominant AU firms: Macquarie Group, and CommSec |
Dominant foreign firms: BNP, Deutsche Bank, Credit Suisse, HSBC, J. P. Morgan Chase, Merrill Lynch, Morgan Stanley, Goldman Sachs, Citigroup |
Extremely competitive |
Long working hours |
Lucrative rewards for those who master the game |
Key skills |
Good analytical and communication skills |
Social and networking skills also pay handsome dividends. |
Growth expectations |
Ongoing development of new financial products and services |
Continued internationalization of corporate finance |
Finance Function: Capital Budgeting
Financial managers single most important activity |
Managers evaluate very large investments in the capital budgeting process |
Companies prosper in a competitive economy only by seeking out the most promising new products, processes, and services to deliver to customers. |
Big companies make huge capital outlays |
ROI drive the value of their firms and wealth of shareholders. |
Consequences of flawed capital budgeting processes are serious |
The capital budgeting process: |
1. Identifying potential investments |
2. Analysing the set of investment opportunities and identifying those that create shareholder value |
3. Implementing and monitoring the investments selected in Step 2 |
Managers have the greatest opportunity to create value for shareholders by acquiring assets that yield benefits greater than their costs
Finance function: Corporate Governance
Important to avoid scandal and damage to reputation |
Systems of incentive / structures that influence good ethical behaviours and decision making |
Intentions |
Determine who benefits most from company activities |
Develop procedures to maximise firm value and to ensure that employees act ethically and responsibly |
Encourage the hiring and promotion of qualified and honest people |
Motivate employees to achieve company goals through salary and other incentives |
Challenges in practice |
Conflicts inevitably arise among stockholders, managers, and other stakeholders. |
Stockholders want managers to work hard and to protect shareholders interests. |
It costs time and money to ensure that managers act appropriately. |
Though managers may wish to maximize shareholder wealth, they do not want to work harder than necessary, especially if others are going to reap most of the benefits. |
Managers and shareholders may decide together to run a company to benefit themselves at the expense of creditors or other stakeholders |
Creditors and other stakeholders generally don't have a voice in corporate governance. |
Strong boards of directors play a vital role in any well-functioning governance system, because boards must hire, fire, pay, and promote senior managers. |
Boards must also develop fixed and contingent compensation packages that align managers incentives with those of shareholders. |
In Australia |
ASIC - Australian Securities and Investments Commission oversees corporate activities |
Est in 1998 |
Corporate, markets and financial services regulator |
ASIC enforce and regulate company and financial services laws to protect Australian consumers investors and creditors |
ASIC oversees the Australian Securities Exchange (ASX) (2006 merger of Aus stock exchange and Sydney Futures Exchange) |
Most work done under the Corporations Act 2001 |
Governments governance |
Countries also struggle |
Governments establish legal frameworks for corporate finance that encourage competitive businesses to develop and efficient financial markets to run properly |
Commercial laws should |
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Provide protection for creditors and minority shareholders |
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Limit opportunities for managers or majority shareholders to transfer corporate wealth from investors to themselves. |
Sole proprietorships
One legal owner |
No distinction between owner and business |
Owners personal property |
Limited life - cease when owner dies or retires |
Limited access to capital - Reinvesting profits, personal loans |
Unlimited personal liability - Personally liable owner for all debts, including lawsuits |
High risk, often not insurable |
Income taxed at personal level |
Limited Partnerships
Sprung from legislation in 2000 |
Unlimited personal liability |
Ideal for start ups with losses in early years - limited partners can use to offset other income tax |
1+ partners with unlimited personal liability who receives a greater share of income |
Other partners |
- Limited liability partners |
- Must be completely passive |
- Name cannot be associated with business |
- Can not take a role in the business |
- Can not be employed by the business |
- No personal liability for debts |
- Can not be sued |
- Income taxed as personal income |
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Modern businesses
Face a modern, knowledge based economy |
Finance role is vital in creating wealth |
Involve people with many different skills and backgrounds working together toward common goals. |
Debt and Equity: The Two Flavors of Capital
Two broad types of capital exist: debt and equity |
Debt capital |
Long term borrowing from creditors |
Borrower pays interest, at a specified annual rate, on the loans principle (full amount borrowed) |
Borrower repays the principal amount at the debts maturity |
Payments made on a fixed schedule |
Creditors have a legally enforceable claim against the firm. |
Defaults on debt payments mean creditors can take legal action to force repayment. |
Creditors can sometimes force the borrowing firm into bankruptcy, out of business and selling (liquidating) assets to repay creditor claims. |
Equity capital |
Business owners contribution |
Expected to remain permanently invested in the company |
Sources of equity capital |
Common stock |
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Bear most of the firms business and financial risk |
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Receive returns on their investments only after creditors and preferred stockholders are paid in full |
Preferred stock |
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Similar to creditors |
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"Preferred Stockholders" |
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Promised a fixed annual payment on their invested capital |
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Claims are not legally enforceable |
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Cannot force a company into bankruptcy if a preferred stock dividend is missed |
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Upon liquidation, preferred stockholders claims are paid before any money is paid to common stockholders. |
Commercial Banking
In Australia is dominated by the 'big four' (75% market share): |
ANZ |
Commonwealth Bank |
NAB |
Westpac |
Hiring |
Banks continue to hire large numbers of new business and finance graduates each year |
Banks train many managers who later migrate to other fields |
Key skills |
Cash flow valuation |
Financial and credit analysis |
Consumer banking vs Commercial banking |
Excellent finance skills |
Intimate knowledge of telecommunications and computer technology |
Investment Banking
Interesting nature of work |
Three main types of activities: |
Helping corporate customers obtain funding by selling securities such as stocks and bonds to investors |
Providing advice to corporate clients on strategic transactions such as mergers and acquisitions |
Trading debt and equity securities for customers or for the firm's own account |
Profitability |
High income potential |
Extraordinarily high since the early 1990s |
Highly volatile industry |
Entry-level salary range $50,000 to more than $80,000, plus bonuses |
Incomes often rise rapidly |
Industry |
Dominant AU firms: Macquarie Group, and CommSec |
Dominant foreign firms: BNP, Deutsche Bank, Credit Suisse, HSBC, J. P. Morgan Chase, Merrill Lynch, Morgan Stanley, Goldman Sachs, Citigroup |
Extremely competitive |
Long working hours |
Lucrative rewards for those who master the game |
Key skills |
Good analytical and communication skills |
Social and networking skills also pay handsome dividends. |
Growth expectations |
Ongoing development of new financial products and services |
Continued internationalization of corporate finance |
Five Basic Corporate Finance Functions
Generally = managing cash flows |
Five basic functions |
Raising capital via external financing |
Capital budgeting function - choosing the best projects in which to invest resources |
Financial management (cash flows) |
Corporate governance |
Risk management |
Finance function: Financing
Raise money to support investment and other activities |
Via |
Internally by retaining and reinvesting operating profits |
Externally from shareholders or creditors |
Internally |
Companies raise about two-thirds of their required funding internally each year |
Externally |
Sole proprietorships and partnerships have limited external funding opportunities |
Corporations have varied opportunities |
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selling equity (common or preferred stock) |
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borrowing money from creditors |
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Young and small corps usually raise equity capital privately, from friends and family, or from professional investors such as venture capitalists. |
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Venture capitalists make high-risk/high-return investments in rapidly growing entrepreneurial businesses |
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Larger corps can go public by conducting an initial public offering (IPO) of stock—selling shares to outside investors and listing the shares for trade on a stock exchange. |
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After IPO, selling additional stock in the future |
Growing Importance of Financial Markets
Traditional intermediaries (banks) useage as providers of debt capital to corporations has declined |
Nonfinancial corporations often go to capital markets for external financing |
New types of intermediaries: pension funds and mutual funds |
Because |
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Modern information processing enables investors to evaluate thousands of potential corporate borrowers and issuers of common and preferred stock equity |
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These intermediaries are major purchasers of the securities non-financial corporations issue |
Primary market transactions |
Corporations sell securities to investors in exchange for cash |
Raise capital |
Firm actually receives the proceeds from issuing securities |
Large fraction of all bond market transactions |
True capital-raising events |
Secondary-market transactions |
After firms initial offering (IPO) investors can sell securities to other investors |
Trades between investors |
Generate no new cash flow for the firm |
Most stock market transactions |
Not true capital-raising events |
Company
An entity created by charter, prescription or legislation |
A 'person' seperate from shareholders |
Many same economic rights / responsibilities as individuals |
Owned by shareholders |
- Shares of stock carry voting rights |
- Shareholders vote at annual meetings to elect boards of directors (BOD) |
- BOD hire / fire managers, and set corporate policys |
Constitution |
- Legal document |
- Created at company's inception |
- Parameters of corporate governance |
- Can only be changed by vote of shareholders |
Can sue and be sued |
Can own property and execute contracts in their own names |
Can be tried and convicted for crimes committed by their employees |
Unlimited life - Perpetual life until explicitly terminated |
Limited liability - Shareholders cannot be held personally liable |
CEOs and chief financial officers (CFOs) can be held personally liable under the Sarbanes-Oxley Act if the debts result from improper accounting practices or fraudulent acts. |
Separable contracting. Can contract individually with managers, suppliers, customers, and ordinary employees, and each contract can be renegotiated, modified, or terminated without affecting other stakeholders. |
Improved access to capital |
- Can borrow money from creditors |
- Can issue preferred and common stock to equity investors |
- Ownership stock claims can be freely traded among investors without obtaining permission from other investors |
- A public company can list shares on a public security market |
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