Maximizing Shareholder Value & Understanding Business Structures, Summaries of Financial Accounting

Download Maximizing Shareholder Value & Understanding Business Structures and more Summaries Financial Accounting in PDF only on Docsity! Republic of the Philippines SORSOGON STATE UNIVERSITY Sorsogon Campus Sorsogon City LEARNING MODULE FINANCIAL MANAGEMENT Module 1: An Overview of Financial Management |. OVERVIEW This chapter will give you an idea of what financial management is all about. We begin the chapter by describing how finance is related to the overall business environment, by pointing out that finance prepares students for jobs in different fields of business, and by discussing the different forms of business organization. For corporations, management’s goal should be to maximize shareholder wealth, which means maximizing the value of the stock. When we say “maximizing the value of the stock,” we mean the “true, long-run value,” which may be different from the current stock price. In the chapter, we discuss how firms must provide the right incentives for managers to focus on long-run value maximization. Good managers understand the importance of ethics, and they recognize that maximizing long-run value is consistent with being socially responsible. Il. LEARNING OUTCOMES After reading and studying this chapter, you will be able to: e Explain the role of finance and the different types of jobs in finance. e Identify the advantages and disadvantages of different forms of business organization. e Explain the links between stock price, intrinsic value, and executive compensation. e Identify the potential conflicts that arise within the firm between stockholders and managers and between stockholders and bondholders, and discuss the techniques that firms can use to mitigate these potential conflicts. @ Discuss the importance of business ethics and the consequences of unethical behavior. Ill. LEARNING EXPERIENCE What is Finance? Finance is defined by Webster’s Dictionary as “the system that includes the circulation of money, the granting of credit, the making of investments, and the provision of banking facilities.” Finance is generally divided into three areas: 1. Financial management, also called corporate finance, focuses on decisions relating to how much and what types of assets to acquire, how to raise the capital needed to purchase assets, and how to run the firm so as to maximize its value. 2. Capital markets relate to the markets where interest rates, along with stock and bond prices, are determined. Also included here are the financial institutions that supply capital to businesses. 3. Investments relate to decisions concerning stocks and bonds. These three areas are closely interconnected. Banking is studied under capital markets, but a bank lending officer evaluating a business’ loan request must understand corporate finance to make a sound decision. Similarly, a corporate treasurer negotiating with a banker must understand banking if the treasurer is to borrow on “reasonable” terms. Finance within an Organization Finance within an Organization Chief Executive Officer (CEO) fo SS Cae sS x ~ [ Chief Operating Officer (COO) Chief Financial Officer (CFO) | Marketing, Production, Human Accounting, Treasury, Credit, Resources, and Other Operating Legal, Capital Budgeting, Departments and Investor Relations Source: Brigham Houston, Fundamentals of Financial Management, South-Western Cengage Learning, USA. P.5 Most businesses and not-for-profit organizations have an organization chart similar to the one shown in Figure 1.1. The board of directors is the top governing body, and the chairperson of the board is generally the highest-ranking individual. The CEO comes next, but note that the chairperson of the board often also serves as the CEO. Below the CEO comes the chief operating officer (COO), who is often also designated as a firm’s president. The COO directs the firm’s operations, which include marketing, manufacturing, sales, and other operating departments. The chief financial officer (CFO), who is generally a senior vice president and the third-ranking officer, is in charge of accounting, finance, credit policy, decisions regarding asset acquisitions, and investor relations, which involves communications with stockholders and the press. Sarbanes and Oxley Act. A law passed by U.S. Congress that requires the CEO and CFO to certify that their firm’s financial statements are accurate. The act was passed by Congress in the wake of a series of corporate scandals involving now-defunct companies such as Enron and WorldCom, where investors, workers, and suppliers lost billions of dollars due to false information released by those companies. Finance versus Economics and Accounting Determinants of Intrinsic Value and Stock Prices Managerial Actions, the Economic Environment, Taxes, and the Political Climate “True” Investor “True” Risk “Perceived” Investor “Perceived” Cash Flows Cash Flows Risk Stock’s Intrinsic Value Stock’s Market Price Market Equilibrium: Intrinsic Value = Stock Price (©2013 Cengage earring. AU Rights Reserves May not be scanned, copied, or dupiata, or posted toa publicly accesible webs The top box indicates that managerial actions, combined with the economy, taxes, and political conditions, influence the level and riskiness of the company’s future cash flows, which ultimately determine the company’s stock price. As you might expect, investors like higher expected cash flows, but they dislike risk; so the larger the expected cash flows and the lower the perceived risk, the higher the stock’s price. The second row of boxes differentiates what we call “true” expected cash flows and “true” risk from “perceived” cash flows and “perceived” risk. By “true,” we mean the cash flows and risk that investors would expect if they had all of the information that existed about a company. “Perceived” means what investors expect, given the limited information they have. The third row of boxes shows that each stock has an intrinsic value, which is an estimate of the stock’s “true” value as calculated by a competent analyst who has the best available data, and a market price, which is the actual market price based on perceived but possibly incorrect information as seen by the marginal investor.Not all investors agree, so it is the “marginal” investor who determines the actual price. When a stock’s actual market price is equal to its intrinsic value, the stock is in equilibrium, which is shown in the bottom box in Figure 1.2. When equilibrium exists, there is no pressure for a change in the stock’s price. Market prices can— and do—differ from intrinsic values; eventually, however, as the future unfolds, the two values tend to converge. Intrinsic Value Actual stock prices are easy to determine—they can be found on the Internet and are published in newspapers every day. However, intrinsic values are estimates, and different analysts with different data and different views about the future form different estimates of a stock’s intrinsic value. Indeed, estimating intrinsic values is what security analysis is all about and is what distinguishes successful from unsuccessful investors. Bia ‘Graph of Actual Prices versus Intrinsic Walues 7 15 or) 2a exe Figure 1.3 graphs a hypothetical company’s actual price and intrinsic value as estimated by its management over time.4 The intrinsic value rises because the firm retains and reinvests earnings each year, which tends to increase profits. The value jumped dramatically in Year 20, when a research and development (R&D) breakthrough raised management's estimate of future profits before investors had this information. The actual stock price tended to move up and down with the estimated intrinsic value, but investor optimism and pessimism, along with imperfect knowledge about the true intrinsic value, led to deviations between the actual prices and intrinsic values. Intrinsic value is a long-run concept. Management's goal should be to take actions designed to maximize the firm’s intrinsic value, not its current market price. Note, though, that maximizing the intrinsic value will maximize the average price over the long run, but not necessarily the current price at each point in time. For example, management might make an investment that lowers profits for the current year but raises expected future profits. Corporate governance. This involves putting in place a set of rules and practices to ensure that managers act in shareholders’ interests while also balancing the needs of other key constituencies such as customers, employees, and affected citizen Effective governance requires holding managers accountable for poor performance and understanding the important role that executive compensation plays in encouraging managers to focus on the proper objectives. Stockholder-Manager Conflicts It has long been recognized that managers’ personal goals may compete with shareholder wealth maximization. In particular, managers might be more interested in maximizing their own wealth than their stockholders’ wealth; therefore, managers might pay themselves excessive salaries. Effective executive compensation plans motivate managers to act in their stockholders’ best interests. Useful motivational tools include (1) reasonable compensation packages, (2) firing of managers who don’t perform well, and (3) the threat of hostile takeovers. Compensation packages should be sufficient to attract and retain able managers, but they should not go beyond what is needed. Compensation policies need to be consistent over time. Also, compensation should be structured so that managers are rewarded on the basis of the stock’s performance over the long run, not the stock’s price on an option exercise date. Direct Stockholder Intervention Years ago most stock was owned by individuals. Today, however, the majority of stock is owned by institutional investors such as insurance companies, pension funds, hedge funds, and mutual funds, and private equity groups are ready and able to step in and take over underperforming firms. These institutional money managers have the clout to exercise considerable influence over firms’ operations. Given their importance, they have access to managers and can make suggestions about how the business should be run. Managers’ Response If a firm’s stock is undervalued, corporate raiders will see it as a bargain and will attempt to capture the firm in a hostile takeover. \f the raid is successful, the target’s executives will almost certainly be fired. This situation gives managers a strong incentive to take actions to maximize their stock’s price. In the words of one executive, “If you want to keep your job, never let your stock become a bargain.” Corporate raiders. Individuals who target corporations for takeover because they are undervalued. Hostile takeover. The acquisition of a company over the opposition of its management. Managers should try to maximize their stock’s intrinsic value and then communicate effectively with stockholders. That will cause the intrinsic value to be high and the actual stock price to remain close to the intrinsic value over time. Stockholder — Debtholder Conflicts Conflicts can also arise between stockholders and debtholders. Debtholders, which include the company’s bankers and its bondholders, generally receive fixed payments regardless of how well the company does, while stockholders do better when the company does better. This situation leads to conflicts between these two groups, to the extent that stockholders are typically more willing to take on risky projects. Another type of stockholder—debtholder conflict arises over the use of additional debt. The more debt a firm uses to finance a given amount of assets, the riskier the firm becomes. Balancing Shareholder Interests and the Interests of the Society Most managers understand that maximizing shareholder value does not mean that they are free to ignore the larger interests of society. Consider, for example, what would happen if a company narrowly focused on creating shareholder value, but in the process the company was unresponsive to its employees and customers, hostile to its local community, and indifferent to the effects its actions had on the environment. In all likelihood, society would impose a wide range of costs on the company. It may find it hard to attract