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Finance and the Financial Manager

Finance and the Financial Manager

Not all businesses are corporations. Small ventures can be owned and managed by a single individual. These are called sole proprietorships. In other cases several people may join to own and manage a partnership. However, we talk about corporate finance. So we need to explain what a corporation is.

Almost all large and medium-sized businesses are organized as corporations. For example, General Motors, Bank of America, Microsoft, and General Electric are corporations. So are overseas businesses, such as British Petroleum, Unilever, Nestle, Volkswagen, and Sony. In each case the firm is owned by stockholders who hold shares in the business.

When a corporation is first established, its shares may all be held by a small group of investors, perhaps the company’s managers and a few backers. In this case the shares are not publicly traded and the company is closely held. Eventually, when the firm grows and new shares are issued to raise additional capital, its shares will be widely traded. Such corporations are known as public companies. Most well-known corporations in the United States are public companies. In many other countries, its common for large companies to remain in private hands.

By organizing as a corporation, a business can attract a wide variety of investors. Some may hold only a single share worth a few dollars, cast only a single vote, and receive a tiny proportion of profits and dividends. Shareholders may also include giant pension funds and insurance companies whose investment may run to millions of shares and hundreds of millions of dollars, and who are entitled to a correspondingly large number of votes and proportion of profits and dividends.

Although the stockholders own the corporation, they do not manage it. Instead, they vote to elect a board of directors. Some of these directors may be drawn from top management, but others are non-executive directors, who are not employed by the firm. The board of directors represents the shareholders. It appoints top management and is supposed to ensure that managers act in the shareholders best interests.

This separation of ownership and management gives corporations permanence. Even if managers quit or are dismissed and replaced, the corporation can survive, and todays stockholders can sell all their shares to new investors without disrupting the operations of the business.

Unlike partnerships and sole proprietorships, corporations have limited liability, which means that stockholders cannot be held personally responsible for the firms debts. If, say, General Motors were to fail, no one could demand that its shareholders put up more money to pay off its debts. The most a stockholder can lose is the amount he or she has invested.

Although a corporation is owned by its stockholders, it is legally distinct from them. It is based on articles of incorporation that set out the purpose of the business, how many shares can be issued, the number of directors to be appointed, and so on. These articles must conform to the laws of the state in which the business is incorporated. For many legal purposes, the corporation is considered as a resident of its state. As a legal “person,” it can borrow or lend money, and it can sue or be sued. It pays its own taxes (but it cannot vote!).

Because the corporation is distinct from its shareholders, it can do things that partnerships and sole proprietorships cannot. For example, it can raise money by selling new shares to investors and it can buy those shares back. One corporation can make a takeover bid for another and then merge the two businesses.

There are also some disadvantages to organizing as a corporation. Managing a corporations legal machinery and communicating with shareholders can be time-consuming and costly. Furthermore, in the United States there is an important tax drawback. Because the corporation is a separate legal entity, it is taxed separately. So corporations pay tax on their profits, and, in addition, shareholders pay tax on any dividends that they receive from the company. The United States is unusual in this respect. To avoid taxing the same income twice, most other countries give shareholders at least some credit for the tax that the company has already paid.

The role of the financial manager

To carry on business, corporations need an almost endless variety of real assets. Many of these assets are tangible, such as machinery, factories, and offices; others are intangible, such as technical expertise, trademarks, and patents. All of them need to be paid for. To obtain the necessary money, the corporation sells claims on its real assets and on the cash those assets will generate. These claims are called financial assets or securities. For example, if the company borrows money from the bank, the bank gets a written promise that the money will be repaid with interest. Thus the bank trades cash for a financial asset. Financial assets include not only bank loans but also shares of stock, bonds, and a dizzying variety of specialized securities.

The financial manager stands between the firms operations and the financial (or capital) markets, where investors hold the financial assets issued by the firm.6 The financial managers role is illustrated in Figure 1.1, which traces the flow of cash from investors to the firm and back to investors again. The flow starts when the firm sells securities to raise cash (arrow 1 in the figure). The cash is used to purchase real assets used in the firms operations (arrow 2). Later, if the firm does well, the real assets generate cash inflows which more than repay the initial investment (arrow 3). Finally, the cash is either reinvested (arrow 4a) or returned to the investors who purchased the original security issue (arrow 4b). Of course, the choice between arrows 4a and 4b is not completely free. For example, if a bank lends money at stage 1, the bank has to be repaid the money plus interest at stage 4b.

man1.jpg

Our diagram takes us back to the financial managers two basic questions. First, what real assets should the firm invest in? Second, how should the cash for the investment be raised? The answer to the first question is the firms investment, or capital budgeting, decision. The answer to the second is the firms financing decision.

Capital investment and financing decisions are typically separated, that is, analyzed independently. When an investment opportunity or project is identified, the financial manager first asks whether the project is worth more than the capital required to undertake it. If the answer is yes, he or she then considers how the project should be financed.

But the separation of investment and financing decisions does not mean that the financial manager can forget about investors and financial markets when analyzing capital investment projects. As we will see in the next chapter, the fundamental financial objective of the firm is to maximize the value of the cash invested in the firm by its stockholders. Look again at Figure 1.1. Stockholders are happy to contribute cash at arrow 1 only if the decisions made at arrow 2 generate at least adequate returns at arrow 3. Adequate means returns at least equal to the returns available to investors outside the firm in financial markets. If your firms projects consistently generate inadequate returns, your shareholders will want their money back.

Financial managers of large corporations also need to be men and women of the world. They must decide not only which assets their firm should invest in but also where those assets should be located. Take Nestl, for example. It is a Swiss company, but only a small proportion of its production takes place in Switzerland. Its 520 or so factories are located in 82 countries. Nestls managers must therefore know how to evaluate investments in countries with different currencies, interest rates, inflation rates, and tax systems.

The financial markets in which the firm raises money are likewise international. The stockholders of large corporations are scattered around the globe. Shares are traded around the clock in New York, London, Tokyo, and other financial centers. Bonds and bank loans move easily across national borders. A corporation that needs to raise cash doesnt have to borrow from its hometown bank. Day-to-day cash management also becomes a complex task for firms that produce or sell in different countries. For example, think of the problems that Nestls financial managers face in keeping track of the cash receipts and payments in 82 countries.

Who is the financial manager?

In this book we will use the term financial manager to refer to anyone responsible for a significant investment or financing decision. But only in the smallest firms is a single person responsible for all the decisions discussed in this book. In most cases, responsibility is dispersed. Top management is of course continuously involved in financial decisions. But the engineer who designs a new production facility is also involved: The design determines the kind of real assets the firm will hold. The marketing manager who commits to a major advertising campaign is also making an important investment decision. The campaign is an investment in an intangible asset that is expected to pay off in future sales and earnings.

Nevertheless there are some managers who specialize in finance. Their roles are summarized in Figure 1.2. The treasurer is responsible for looking after the firms cash, raising new capital, and maintaining relationships with banks, stockholders, and other investors who hold the firms securities.

man2.jpg

For small firms, the treasurer is likely to be the only financial executive. Larger corporations also have a controller, who prepares the financial statements, manages the firms internal accounting, and looks after its tax obligations. You can see that the treasurer and controller have different functions: The treasurers main responsibility is to obtain and manage the firms capital, whereas the controller ensures that the money is used efficiently.

Still larger firms usually appoint a chief financial officer (CFO) to oversee both the treasurers and the controllers work. The CFO is deeply involved in financial policy and corporate planning. Often he or she will have general managerial responsibilities beyond strictly financial issues and may also be a member of the board of directors.

The controller or CFO is responsible for organizing and supervising the capital budgeting process. However, major capital investment projects are so closely tied to plans for product development, production, and marketing that managers from these areas are inevitably drawn into planning and analyzing the projects. If the firm has staff members specializing in corporate planning, they too are naturally involved in capital budgeting.

Because of the importance of many financial issues, ultimate decisions often rest by law or by custom with the board of directors. For example, only the board has the legal power to declare a dividend or to sanction a public issue of securities. Boards usually delegate decisions for small or medium-sized investment outlays, but the authority to approve large investments is almost never delegated.

Separation of ownership and management

In large businesses separation of ownership and management is a practical necessity. Major corporations may have hundreds of thousands of shareholders. There is no way for all of them to be actively involved in management: It would be like running New York City through a series of town meetings for all its citizens. Authority has to be delegated to managers.

The separation of ownership and management has clear advantages. It allows share ownership to change without interfering with the operation of the business. It allows the firm to hire professional managers. But it also brings problems if the managers and owners objectives differ. You can see the danger: Rather than attending to the wishes of shareholders, managers may seek a more leisurely or luxurious working lifestyle; they may shun unpopular decisions, or they may attempt to build an empire with their shareholders money.

Such conflicts between shareholders and managers objectives create principal–agent problems. The shareholders are the principals; the managers are their agents. Shareholders want management to increase the value of the firm, but managers may have their own axes to grind or nests to feather. Agency costs are incurred when (1) managers do not attempt to maximize firm value and (2) shareholders incur costs to monitor the managers and influence their actions. Of course, there are no costs when the shareholders are also the managers. That is one of the advantages of a sole proprietorship. Ownermanagers have no conflicts of interest.

Conflicts between shareholders and managers are not the only principalagent problems that the financial manager is likely to encounter. For example, just as shareholders need to encourage managers to work for the shareholders interests, so senior management needs to think about how to motivate everyone else in the company. In this case senior management are the principals and junior management and other employees are their agents.

Agency costs can also arise in financing. In normal times, the banks and bondholders who lend the company money are united with the shareholders in wanting the company to prosper, but when the firm gets into trouble, this unity of purpose can break down. At such times decisive action may be necessary to rescue the firm, but lenders are concerned to get their money back and are reluctant to see the firm making risky changes that could imperil the safety of their loans. Squabbles may even break out between different lenders as they see the company heading for possible bankruptcy and jostle for a better place in the queue of creditors.

Think of the companys overall value as a pie that is divided among a number of claimants. These include the management and the shareholders, as well as the companys workforce and the banks and investors who have bought the companys debt. The government is a claimant too, since it gets to tax corporate profits.

All these claimants are bound together in a complex web of contracts and understandings. For example, when banks lend money to the firm, they insist on a formal contract stating the rate of interest and repayment dates, perhaps placing restrictions on dividends or additional borrowing. But you cant devise written rules to cover every possible future event. So written contracts are incomplete and need to be supplemented by understandings and by arrangements that help to align the interests of the various parties.

Principalagent problems would be easier to resolve if everyone had the same information. That is rarely the case in finance. Managers, shareholders, and lenders may all have different information about the value of a real or financial asset, and it may be many years before all the information is revealed. Financial managers need to recognize these information asymmetries and find ways to reassure investors that there are no nasty surprises on the way.

Suppose you are the financial manager of a company that has been newly formed to develop and bring to market a drug for the cure of toetitis. At a meeting with potential investors you present the results of clinical trials, show upbeat reports by an independent market research company, and forecast profits amply sufficient to justify further investment. But the potential investors are still worried that you may know more than they do. What can you do to convince them that you are telling the truth? Just saying Trust me wont do the trick. Perhaps you need to signal your integrity by putting your money where your mouth is. For example, investors are likely to have more confidence in your plans if they see that you and the other managers have large personal stakes in the new enterprise. Therefore your decision to invest your own money can provide information to investors about the true prospects of the firm.

Taken from Principles of Corporate Finance by Richard A. Brealey and Stewart C. Myers (7th edition)

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