I. Financial Markets and the Corporation. Role of Financial Management. II. What is Financial Management? Financial Markets

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1 I. Financial Markets and the Corporation Firm Capital $$$ Investors Financial Markets 1 Role of Financial Management II. What is Financial Management? CFO Financial Management is the study of ways to answer the following three questions. Firm Invest Cash Issue Securities Investors 1. What long-term investments should we take on? Reinvestments Cash flows from firm s investments Dividends, Interests 2. Where will you get the long-term financing to pay for your investment? Taxes Government 3. How will you manage your everyday financial activities? 4

2 Financial Management Decisions Balance Sheet Model of a Firm Capital Budgeting Identification of investment opportunities that are worth more than they cost to acquire The size, timing, and risk of future cash flows is important. Financing (Capital Structure Decisions) How much to borrow? What are the least expensive sources of funds? Working Capital Management Decisions to ensure that the firm has sufficient resources to continue operations without costly interruptions. Capital budgeting (left-hand side) Working Capital Mgmt Capital structure (right-hand side) 5 6 III. What Should You Try to Achieve with Financial Management? The Goal of Financial Management What should be the goal(s) of managing a corporation? 7 8

3 IV. Managers vs. Shareholders Agency Relationship/Agency Problem Separation of Ownership and Control: One distinct characteristic of a corporation is the separation of ownership and control. The managers (control) are hired by shareholders (ownership) and expected to achieve the maximization of shareholder value. Service Reward Shareholders (Principal) Manager (Agent) 9 10 Moral Hazard Agency problem: Conflict of interest between the firm s owners (shareholders) and the management of a firm Are there any effective mechanisms/tools to curb managers tendency to seek their own interest at the cost of shareholders? (Corporate Governance) There is possibility that managers do not act in the shareholders best interest. Agency conflicts reduce firm value (and shareholder wealth) - Why? Agency problem creates more adverse effects on diversely held firms (i.e., greater agency costs for diversely held firms) - Why? 11 12

4 Financial Management and Value Creation Managers can maximize firm value or create firm value by finding out good projects that can add value to the firm. Also, managers can create firm value by finding cheaper source of financing. Also, managers can create firm value by effectively maintaining firm s short-term assets. These are what financial managers should do. Which investment project should I take on? Is it better just not to invest at all? To create value, which financing method should I use? To create value, what should I do with free cash flows? What should I do with tax payments to create value? If we borrow, will that create value? Discussion Question Can the goal of maximizing the value of the stock conflict with other goals, such as avoiding unethical or illegal behavior? In particular, do you think subjects like customer and employee safety, the environment, and the general good of society fit in this framework, or are they essentially ignored? 15

5 Discussion Question RJR Nabisco: Case Barbarians at the Gate In response to the Sarbanes-Oxley Act, many small firms in the United States have opted to go dark and delist their stock. Why might a company choose this route? What are the costs of going dark? CASE MBO: Nabisco Barbarians at the Gate In October 1988, the common stock of RJR Nabisco was traded at $56 a share. Then, suddenly, the board of directors of RJR Nabisco revealed that Ross Johnson, the firm s CEO, had formed a group of investors that proposed to buy all RJR s stock for $75 per share in cash and take the company private. At the news the RJR s price immediately jumped from $56 to $75 in one day (about a 36% gain in a single day!). Four days later, KKR (Kohlberg, Kravis, and Roberts) jumped in the frenzy and offered to buy the RJR stock at $90 a share. The resulting bidding contest had many turns and surprises during the following weeks. 19 MBO: Nabisco Barbarians at the Gate Finally, it was KKR s offer of $109 per share in cash and convertible bonds vs. Johnson s offer of $112 in cash and securities. In the end, The board of RJR chose KKR despite the $3 premium offered by Johnson. The final decision was reached exactly 33 days after the initial bid was made by Johnson. During the period (of 33 days), the stock price of RJR rose from $56 to $109 awhopping 95% return! KKR used $2.5 billion to buy out RJR. The $2.5 billion deal was financed through junk bonds issued on the RJR s assets. Like in this case, when an acquisition of a company is financed through a large debt issue, the event is called a leveraged buyout (LBO). 20

6 Question MBO: Nabisco Barbarians at the Gate The stock price of RJR jumped by 96% in just mere 33 days. Then, where did this added value come from? Does it suggest that the market is irrational? Who is(are) the winner(s) in this game? 21