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Dr Catherine S F Ho
Dr Catherine S F Ho
Learning Goals
1. Define finance and its major areas. 2. Describe the managerial finance function and its relationship to economics and accounting. 3. Identify the primary activities of the financial manager. 4. Explain the goal of the firm, corporate governance, the role of ethics, and the agency issue.
Dr Catherine S F Ho
What is Finance?
Finance can be defined as the art and science of managing money. Finance is concerned with the process, institutions, markets, and instruments involved in the transfer of money among individuals, businesses, and governments. Enable managers to make effective financial decisions
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Dr Catherine S F Ho
Corporate Organization
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Nord Department Stores is applying marginalmarginalcost benefit analysis to decide whether to replace a computer:
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Now contrast the differences in performance under the accounting method versus the cash method.
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INCOME STATEMENT SUMMARY ACCRUAL Sales Less: Costs Net Profit/(Loss) $100,000 (80,000) $ 20,000
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Finance and accounting also differ with respect to decision-making: decisionAccountants devote most of their attention to the collection and presentation of financial data. Financial managers evaluate the accounting statements, develop additional data, and make decisions on the basis of their assessment of the associated returns and risks.
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Profit maximization fails to account for differences in the level of cash flows (as opposed to profits), the timing of these cash flows, and the risk of these cash flows.
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Profit maximization may not lead to the highest possible share price for at least three reasons:
1.
2.
3.
Timing is importantthe receipt of funds sooner rather than later important is preferred Profits do not necessarily result in cash flows available to stockholders Profit maximization fails to account for risk
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Corporate Governance
Corporate Governance is the system used to direct and control a corporation. It defines the rights and responsibilities of key corporate participants such as shareholders, the board of directors, officers and managers, and other stakeholders and and rules and procedures for making corporate decisions. Board of Directors sets policies that specify ethical practices and protect stakeholder interests. interests. Presence of institutional investors exert greater influence on CG through ability to affect stock prices
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Government regulation generally shapes the corporate governance of all firms. During the recent decade, corporate governance has received increased attention due to several high-profile highcorporate scandals involving abuse of corporate power and, in some cases, alleged criminal activity by corporate officers.
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A principal-agent relationship is an arrangement in principalwhich an agent acts on the behalf of a principal. For example, shareholders of a company (principals) elect management (agents) to act on their behalf. Agency problems arise when managers place personal goals ahead of the goals of shareholders. Agency costs arise from agency problems that are borne by shareholders and represent a loss of shareholder wealth. In addition to the roles played by corporate boards, institutional investors, and government regulations, corporate governance can be strengthened by ensuring that managers interests are aligned with those of shareholders. A common approach is to structure management Dr Catherine with 36 compensation to correspond S F Ho firm performance
Incentive plans are management compensation plans that tie management compensation to share price; one example involves the granting of stock options. Performance plans tie management compensation to measures such as EPS or growth in EPS. Performance shares and/or cash bonuses are used as compensation under these plans. When a firms internal corporate governance structure is unable to keep agency problems in check, it is likely that rival managers will try to gain control of the firm. The threat of takeover by another firm, which believes it can enhance the troubled firms value by restructuring its management, operations, and financing, can provide a strong source of external corporate governance.
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Institutional investors Market Forces Agency Issue: Resolving the Problem Agency Costs External Audit Costs Threat of takeovers
Management Compensation
Incentive Plans
Performance Plans
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Agency Relationship
Firms incur agency costs to prevent or minimize agency problems. It is unclear whether they are effective in practice. The four categories of agency cost are
monitoring expenditures incurred by the owners for audit and control procedures, bonding expenditures to protect against the potential consequences of dishonest acts by managers, structuring expenditures that use managerial compensation plans to provide financial incentives for managerial actions consistent with share price maximization, and opportunity costs resulting from the difficulties typically encountered by large organizations in responding to new opportunities.
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Agency Relationship
The agency problem and the associated agency costs can be reduced by a properly constructed and followed corporate governance structure. The structure of the governance system should be designed to institute a system of checks and balances to reduce the ability and incentives of management to deviate from the goal of shareholder wealth maximization.
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Agency Relationship
Structuring expenditures are currently the most popular way to deal with the agency problemand problem also the most powerful and expensive. Compensation plans can be either incentive or performance plans. Incentive plans tie management plans. performance to share price. Managers may receive stock options giving them the right to purchase stock at a set price. This provides the incentive to take actions that maximize stock price so that the price will rise above the options price level. This form of compensation plan has fallen from favor recently because market behavior, which has a significant effect on share price, is not under managements control.
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Agency Relationship
As a result, performance plans are more popular today. With these, compensation is based on performance measures, such as earnings per share (EPS), EPS growth, or other return ratios. Managers may receive performance shares and/or cash bonuses when stated performance goals are reached. In practice, recent studies have been unable to document any significant correlation between CEO compensation and share price.
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LG1
LG2 LG3
Describe the goal of the firm, and explain why maximizing the value of the firm is an appropriate goal for a business.
The goal of the firm is maximize its value, and therefore the wealth of its shareholders. Maximizing the value of the firm means running the business in the interest of those who own it it the shareholders.
LG4
Describe how the managerial finance function is related to economics and accounting.
The financial manager must understand the economic environment and rely heavily on the economic principle of marginal cost cost benefit analysis to make financial decisions. Financial managers Dr Catherine S F Ho 46 use accounting but concentrate on cash flows and decision making.
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Describe the nature of the principle-agent relationship principlebetween the owners and managers of a corporation, and explain how various corporate governance mechanisms attempt to manage agency problems.
This separation of owners and managers of the typical firm is representative of the classic principal-agent relationship, where the principalshareholders are the principles and mangers are the agents. A firms corporate governance structure is intended to help ensure firm that managers act in the best interests of the firms shareholders, firm and other stakeholders, and it is usually influenced by both internal and external factors.
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