Agency theory in financial management ppt

Chapter

McGraw-Hill/Irwin

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Goals and Functions of Financial Management

1

Chapter Outline

Introduction to Finance
Risk-Return Tradeoff
Forms of Organizations
Corporate Governance
Goals of Financial Management
Social Responsibility and Finance
Role of Financial Markets
Financial Management

Financial Management or business finance is concerned with managing an entity’s money.

For example, a company must decide:

where to invest its money.

whether or not to replace an old asset.

when to issue new stocks and bonds.

whether or not to pay dividends.

Relationship between Finance, Economics and Accounting

Economics provides structure for decision making in many important areas.
Provides a broad picture of economic environment.

Accounting provides financial data in various forms.
Income statements, balance sheets, and statement of cashflows.
Finance links economic theory with the numbers of accounting.
Evolution in the Field of Finance

At the turn of the century: Emerged as a field separate from economics.
By 1930s: Financial practices revolved around such topics as:
Preservation of capital.
Maintenance of liquidity.
Reorganization of financially troubled corporation.
Bankruptcy.
Evolution in the Field of Finance (cont’d)

By mid-1950s: Finance becomes more analytical.
Financial Capital (accounting capital/ money) was used to purchase Real Capital (economic capital/ long-term plant and equipment).
Cash and inventory management
Capital structure theory
Dividend policy
Recent Issues in Finance

Recent focus has been on:
Risk-return relationships.
Maximization of returns for a given level of risk.
Portfolio management.
Capital structure theory.
New financial products with a focus on hedging are being widely used.
Recent Issues in Finance (cont’d)

The following are significant to financial managers during decision making:
Effects of inflation and disinflation on financial forecasting.
Required rates of return for capital budgeting decisions.
Cost of capital.
Advances in Internet and Finance

Internet and its acceptance has enabled acceleration of e-commerce solutions for “old economy” companies.
E-commerce solutions for existing companies
B2C

B2B

Spurt in new business models and companies
Amazon.com

eBay

Advances in Internet and Finance (cont’d)

For a financial manager e-commerce impacts financial management because it affects the pattern and field through which cash flows through the firm.
B2C Model: Products are bought with credit cards, credit card checks are performed, and selling firms get the cash flow faster.
B2B: Orders can be placed, inventory managed, and bids to supply products can be accepted –all online.
Functions of the Financial Manager

Risk-Return Trade-Off

Influences operational side (capital versus labor/ Product A versus Product B)
Influences financial mix (stocks versus bonds versus retained earnings)
Stocks are more profitable but riskier.

Savings accounts are less profitable and less risky (or safer)

Financial manager must choose appropriate combinations
Sole Proprietorship

Represents single-person ownership
Advantages:
Simplicity of decision-making.
Low organizational and operational costs.
Drawback
Unlimited liability to the owner.
Profits and losses are taxed as though they belong to the individual owner.
Partnership

Similar to sole proprietorship except there are two or more owners.
Articles of partnership: Specifies ownership interest, the methods for distributing profits, and the means of withdrawing from the partnership.
Limited partnership: One or more partners are designated as general partners and have unlimited liability of the debts of the firm; other partners designated limited partners and are liable only for their initial contribution.
Corporation

Corporation
Articles of incorporation: Specify the rights and limitations of the entity.

Its owned by shareholders who enjoy the privilege of limited liability.

Has a continual life.

Key feature is the easy divisibility of ownership interest by issuing shares of stock.

Corporation (cont’d)

Disadvantage:
The potential of double taxation of earnings.
Subchapter S corporation: Income is taxed as a direct income to stockholders and thus is taxed only once as normal income.
Corporate Governance

Agency theory
Examines the relationship between the owners and managers of the firm.
Institutional investors
Have more to say about the way publicly owned companies are managed.
Public Company Accounting Oversight Board (PCAOB)

Sarbanes-Oxley Act of 2002

Set up a five member Public Company Accounting Oversight Board (PCAOB) with responsibility for:
Auditing standards within companies
Controlling the quality of audits
Setting rules and standards for the independence of the auditors.
Major focus is to make sure that publicly-traded corporations accurately present their assets, liabilities, and equity and income on their financial statements.
Goals of Financial Management

Valuation Approach
Maximizing shareholder wealth (shareholder wealth maximization)
Management and stockholder wealth
Retention of position of power in long run is by becoming sensitized to shareholder concerns.

Sufficient stock option incentives to motivate achievement of market value maximization.

Powerful institutional investors are increasing management more responsive to shareholders.

Social Responsibility

Adoption of policies that maximize values in the market attracts capital, provides employment and offers benefits to the society.
Certain cost-increasing activities may have to be mandatory rather than voluntary initially, to ensure burden falls equally over all business firms.
Ethical Behavior

Ethical behavior creates invaluable reputation.
Insider trading
Protected against by the Securities and Exchange Commission (SEC).
The Role of Financial Markets

Financial markets are indicators of maximization of shareholder value and the ethical or the unethical behavior that may influence the value of the company.
Participants in the financial market range over the public, private and government institutions.
Public financial markets
Corporate financial markets
Structure and Functions of the Financial Markets

Money markets
Securities in this market include commercial paper sold by corporations to finance their daily operations or certificates of deposit with maturities of less than 12 months sold by banks.

Capital markets
Long-term markets

Securities include common stock, preferred stock and corporate and government bonds.

Stocks versus Bonds

Stock = ownership or equity
Stockholders own the company

Bond = debt or IOU
Bondholders are owed $ by company

Allocation of Capital

Primary market
When a corporation uses the financial markets to raise new funds, the sale of securities is made by way of a new issue.
Secondary market
When the securities are sold to the public (institutions and individuals).
Financial managers are given a feedback about their firms’ performance.
Return Maximization and Risk Minimization

Investors can choose risk level that meets their objective and maximizes return for that given level of risk.
Companies that are rewarded with high-priced securities can raise new funds in the money and capital markets at a lower cost compared to competitors.
Firms pay a penalty for failing to perform competitively.
Restructuring

Restructuring can result in:
Changes in the capital structure (liabilities and equity on the balance sheet).
Selling of low-profit-margin divisions with the proceeds of the sale reinvested in better investment opportunities.
Removal or large reductions in the of current management team.
It has resulted in acquisitions and mergers.
Internationalization of Financial Markets

Allocation of capital and the search for low cost sources of financing on the rise in global market.
The impact of international affairs and technology has resulted in the need for future financial managers to understand
International capital flows.

Computerized electronic funds transfer systems.

Foreign currency hedging strategies.

Technological Impact on Capital Market

Consolidation among major stock markets and mergers of brokerage firms with domestic and international partners.
Electronic markets have gained popularity as against traditional organized exchanges and NASDAQ.
Resulted in the merger of NYSE with Archipelago and NASDAQ bought out Insinet from