INTRODUCTIONTO

FINANCIALMANAGEMENT

Keyconceptsandskills
Knowthebasictypesoffinancialmanagementdecisionsand
theroleofthefinancialmanager
Knowthegoaloffinancialmanagement
Understandtheconflictsofinterestthatcanarisebetween
ownersandmanagers
Understandcorporategovernanceanditsimplications

Outline
Whatiscorporatefinance?
Corporateorganization
Goaloffinancialmanagement
Relationsbetweencorporationandstakeholders
Corporategovernance

Corporateorganization
Shareholders

Boardofdirectors

ChairmanoftheBoard

ChiefExecutiveOfficer(CEO)

VP/COO

VP/CFO

SalesManager

MarketingManager

TaxManager

CostManager

HRManager

PRManager

RiskManager

AccountManager
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Corporatecashflows

Invests
inassets
Currentassets
(B)
Noncurrentassets
Currentassets
Fixedassets

Cashfromfirmsecuritiesissues(A)

Retained
cashflows(F)
Cashflow
fromfirm(C)

Totalassetvalue

Ultimately,firmmustbea
cashgeneratingactivity.

Dividendsand
debtpayments(E)
Taxes(D)

Firminvests
inassets(B)

Government

Financial
markets

Currentliabilities
Shorttermdebt
Noncurrent
liabilities
Longtermdebt
Equityshares
Equityshares
Totalfirmvalue
toinvestors

Cashflowsfromfirm
mustexceed cashflows
fromfinancialmarkets.
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Whatiscorporatefinance?
Asanownerofthefirm,whatcorporatefinancedecisions
doyouhavetomake?

Whatiscorporatefinance?
1. Investment
Choosebestprojects
Capitalbudgeting
2. Financing
Choosesourcesoffinancing
Capitalstructure
3. Liquidity
Ensurecash&inventory
Networkingcapital
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Goaloffinancialmanagement
Whatistheultimategoalofcorporatefinancialmanagement?
Shareholders

Boardofdirectors

ChairmanoftheBoard

ChiefExecutiveOfficer(CEO)

VP/COO

VP/CFO

Whatarethesemanagerskeyobjectives?
SalesManager

MarketingManager

TaxManager

CostManager

HRManager

PRManager

RiskManager

AccountManager
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Goaloffinancialmanagement
Apubliccompanycouldpursuemanyobjectives:profits,
revenues,size,marketshare,marketvalue,stockprice,
employeebenefits,socialprofile,internationalprofile,etc.
Thegoaloffinancialmanagementistomaximizethemarket
valueoftheexistingownersequity.
Thefinancialmanagersprimarygoalistoincreasethevalue
ofthefirmby:
Selectingvaluecreatingprojects
Makingsmartfinancingdecisions
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Goaloffinancialmanagement
Firmsshoulddoanythingtomaximizestockholderwealth?
Ownersdonotmeetemployeeneeds?
Customersarenotcriticaltosuccess?
Thecompanyhastobeasocialoutlaw?
Whyfocusonfirmvalue?

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Goaloffinancialmanagement
Whyshareownervalue?(CEOSeries13,Feb1996)
byRobertC.Goizueta,ChairmanandCEOofCocaCola
Whatdoesshareownervaluemean?
Its simply the value that is assigned to our company by the marketplace, either in
total or on a pershare basis based on the incremental economic value generated
by our business operations.
Managing our business for shareowner value means making decisions that maximize
the economic value added to our company today, and the investment communitys
confidence in our future.

Whyshareownervalue?
Increasingshareownervalueovertimeisthejobsocietydemandsofus.
Increasingshareownervalueenablesustocontributetosocietyinmeaningfulways.
Focusingoncreatingvalueoverthelongtermkeepsusfromactingshortsighted.
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Corporateinteractions
STOCKHOLDERS
hire&fire
managers

maximize
shareholderwealth
costscanbe
tracedtofirm

protectbondholder
interests

MANAGERS

BONDHOLDERS
lendmoney

SOCIETY
minimize
socialcosts

revealinformation
honestlyandtimely

marketsassess
effectonvalue

FINANCIALMARKETS

Whathappensifmanagersdontactinstakeholdersinterests?
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Corporatecounterreactions
STOCKHOLDERS
badmanagersputonnotice:
activists,hostiletakeovers
corporategoodcitizenconstraints:
morelaws,investorbacklash

MANAGERS

BONDHOLDERS

SOCIETY

selfproctection:
covenants,newtypes

punishmentformisleadingmarket
morescepticalinvestors,analysts

FINANCIALMARKETS

Whathappensifmanagersdontactinstakeholdersinterests?
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Corporategovernance

Definition

Rootoftheproblem

Bestpractices

Marketforcorporatecontrol

OverviewofM&A

ReasonsforM&A

ReturnstoM&Aparties

Antitakeoverprotections

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Corporategovernance>Definition
Controlmechanismstoensuremanagersactinstakeholdersinterests
*Source:Larcker(2006)

EfficientCapital
Markets

Board
Investors

Creditors

Regulatory
Enforcement

Auditors
Customers

Managers

Analysts

LegalTradition

Suppliers

Unions
Regulators

Media

AccountingStandards

SocietalandCulturalValues

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Corporategovernance>HealthSouth

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Corporategovernance>HealthSouth

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Corporategovernance>HealthSouth

Whatwastheboardofdirectorsdoing?
Compensationcommitteemetonlyonceduring2001.
Forbes (April30,2002):CEOhasprovidedsubparreturnsto
shareholderswhileearninghugesumsforhimself.Still,the
boarddoesnttosshimout.

Whatwastheexternalauditor(E&Y)doing?
Auditcommitteemetonlyonceduring2001.
PresidentandCFOwerepreviouslyauditorsforE&Y.
Auditfee=$1.2millionversusotherfees=$2.5million.

Whatweretheanalystsdoing?
UBSanalysthadastrongbuyonHealthSouth.
UBSearned$7millionininvestmentbankingfees.
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Corporategovernance>HealthSouth
Perhapsnotsurprisingly,theCEOrepeatedlyreceivedstockoptions
datedatlowpointsinthecompanysstockprice(backdating).

HealthSouth(HRC)
$30

$28

$26

$24

$22
Jun 97

Jul 97

Aug 97

Sep 97

Oct 97

CEO stock option grant date: Aug 14, 1997

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Corporategovernance>isolatedincident?
U.S.Companies

NonU.S.Companies

AIG

Ahold

Adelphia

Parmalat

BearStearns

RoyalDutch/Shell

Enron

Satyam

GlobalCrossing

Seimens

LehmanBrothers

etc

Tyco

WorldCom

etc

U.S. and Non-U.S.

companies are equally
likely to have to
restate earnings
Source: Glass Lewis

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Corporategovernance>Rootoftheproblem

Ownervsmanagertheownersofthecompanyareseparatefromthe
managementofthecompany

Agencyproblem managementtakesselfinterestedactionsthatare
notintheinterestofshareholders.

Agencycostsshareholdersbearthecostoftheseactions.

To meet Wall Street estimates:

80% of CFOs would reduce discretionary spending
60% would delay investment in a valuable new project
40% would accelerate recognition of revenue (if justified)
40% would provide incentives to customers to buy early
30% would draw down reserves
Source: Graham, Harvy, and Rajgopal (2006)

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Corporategovernance>Agencycostexamples

Insufficienttimeandeffortonbuildingshareholdervalue

Inflatedcompensationorexcessiveperquisites

Manipulatingfinancialresultstoincreasebonusorstockprice

Excessiverisktakingtoincreaseshorttermresultsandbonus

Failuretogroomsuccessorssomanagementisindispensible

Pursuinguneconomicacquisitionstogrowtheempire

Thwartinghostiletakeovertoprotectjob

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Corporategovernance>bestpractices?

In1992,theCadburyCommitteeinLondonrecommendedindependent
directorsandindependentauditcommittee.
Enronwascompliantwithindependencestandards,yetcollapsed.

In2002,SarbanesOxleyintheU.S.enhancedthepenaltiesfor
misrepresentations.
Refcohid$430millioninloanstoitsCEO,2monthsafteritwentpublic.

RiskMetrics/InstitutionalShareholderServices(ISS)wasfoundedin1985to
provideobjectivegovernanceresearchandrecommendations,endtoend
proxyvotinganddistributionsolutions.
ISSgaveHealthSouthagovernanceratingthatplaceditinthetop8%of
itsindustry.HealthSouthofficialswerelaterchargedwithfraud!
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Corporategovernance>goodgovernance?

Investorssaytheyarewillingtopayapremiumforawellgovernedfirm.

Thesizeofthepremiumvariesbycountry.
Higherpremium:countrieswithweakerlegal/regulatoryprotections
forminorityshareholders.
Lowerpremium:countrieswithstrongerprotections.
What premium would you be willing
to pay for a company located in:
Russia: 38%
China: 25%
Brazil: 24%
India: 23%
South Korea: 20%
U.S.: 14%
Germany: 13%
U.K: 12%
Source: McKinsey & Co. (2002)

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Corporategovernance>notalwaysclear

IsthegovernanceoffirmAreallyworsethanthegovernanceoffirmB?

Whatistheevidence?
Would you be willing to pay a premium for Company Bs stock?
(assuming similar performance history and current operating conditions)
Company A, Poor Governance
Minority of outside directors
Outside directors have financial
ties with management
Directors own little or no stock
Directors compensated only with
cash
No formal director evaluation
process
Very unresponsive to investor
requests for information on
governance issues

Company B, Good Governance

Majority of outside directors
Outside directors are independent;
no ties to management
Directors have significant stock
Directors compensated with cash &
stock
Formal director evaluation is in
place
Very responsive to investor
requests for information on
governance issues

Source: McKinsey & Co. (2002)

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Corporategovernance>Discipliningmechanisms

Awellfunctioninggovernancesystemconsistsofmorethanjustthe
boardofdirectorsandtheexternalauditor.

Itincludesalldiscipliningmechanismslegal,regulatory,andmarket
driventhatinfluencemanagementtoactintheinterestof
shareholders.Examplesinclude:
Labormarket:FailureleadstoCEOtermination.
Capitalmarket:Failureleadstohighercostofcapital.
Regulatoryenvironment:Violationsleadtolitigation.

Similarly,themarketforcorporatecontrolputspressureonthe
CEOtoperform,orrisksaleofcompanytonewowners.
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Corporategovernance>Marketforcorporatecontrol

Henry Manne: The lower the stock price, relative to what it could be with
more efficient management, the more attractive the takeover becomes to
those who believe that they can manage the company more efficiently.
Stock prices in part reflect management performance.

Rather than remove an executive, the board might decide to sell the entire
company to new owners who can manage its assets more profitably (e.g.,
through changes to strategy, cost structure, capital structure, etc.).

A sale makes sense if the value of firm to new owners (less transaction
costs) is greater than value to current owners.
Manne (1965)

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Corporategovernance>Marketforcorporatecontrol

The market for corporate control consists of all mergers, acquisitions, and
reorganizationsincluding those by a competitor, a conglomerate, or a
private equity buyer.

The company making the offer is the acquirer (or bidder)

The subject of the offer is the target.

What are the reaons for M&A?

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Corporategovernance>Strategicreasons

Financial synergies:
The acquiring firm believes it can increase profits through revenue
improvements, cost reduction, or vertical integration. This is the logic
behind a strategic buyer.

Diversification:
Two companies whose earnings are uncorrelated might benefit by relying
on the capital generated when one business is thriving to help the other
when it is struggling. This is the logic behind a conglomerate structure.

Change in ownership:
New owner group might have superior access to capital, managerial
expertise, or other resources. This is the logic behind a private equity
buyer.
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Corporategovernance>Nonstrategicreasons

Empire building: The acquirer purchases a target primarily for the sake of
managing a larger enterprise.

Hubris: Overconfidence on the part of management that it can more

efficiently manage a target than current owners can.

Herding behavior: The senior management of one company pursues an

acquisition because its competitors have recently completed acquisitions.

Compensation incentives: The management of the target company agrees

to an acquisition primarily because it stands to receive a large payment
upon change in control.
The average CEO of a large U.S. company stands to receive $29 million
in cash and accelerated equity grants following a change in control.
Equilar (2007)

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Corporategovernance>Expectedvalueofatakeover

Markets expect the incremental value of an acquisition to flow to the

target rather than to the acquirer.

The target:
Receives doubledigit takeover premium offer.
Experiences greater excess returns in hostile deals.
Experiences greater excess returns in allcash deals.

The acquirer:
Experiences no excess returns following bid.
Experiences negative excess returns for hostile bid.
Experiences greater declines if equityfinanced bid.

Eckbo (2009); Servaes (1991); Andrade, Mitchell, and Stafford (2001); Martynova and Renneboog (2008); Goergen and Renneboog (2004)

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Corporategovernance>Realizedvalueofatakeover

Acquirers realize less value following a merger than originally expected.

The acquirer:
Underperforms peers on a one to threeyear basis.
Performs worse if acquisition is financed with equity.
Decreases investment in working capital and cap ex.

Acquisitions are also highly disruptive:

They require significant management attention.
They lead to elevated turnover rates for up to 10 years following
consummation of the deal.

Martynova and Renneboog (2008); Krug and Shill (2008)

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Corporategovernance>Antitakeoverprotections

A company that does not want to become the target of an unsolicited

takeover might adopt defense mechanisms to discourage or prevent a bid.

Antitakeover protections might give a company time to pursue longterm

value creation without threat of takeover; or to enhance bargaining power
to secure a higher bid.

Common antitakeover protections include:

Poison pill (28% of US companies currently have in place)
Dualclass shares (8%)
Staggered board (50%)
Restricted rights to call a special meeting (47%)
Shareholders cannot vote by written consent (30%)
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Corporategovernance>Antitakeoverprotections
Research demonstrates that antitakeover protections generally reduce
governance quality and shareholder value.
In evaluating antitakeover measures, shareholders and the board might
consider the following:
1.

Does the company require exposure to the capital markets to keep

management in check? Or, are other governance features
sufficient for this purpose?

2.

What are the motives of potential acquirers? Are they consistent

with the longterm objectives of the company?

3.

Are antitakeover defenses truly adopted for shareholder protection,

or to entrench management?

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Corporategovernance>Conclusion

Corporategovernanceisanimportantdeviceforcontrollingself
interestedexecutives.

However,wouldyouknowgoodgovernanceifyousawit?

Governanceisacontroversialtopic.Thedebateischaracterizedby
considerablehypebutfewhardfacts.

Togetthestorystraight,wemustlookattheevidence.Sometimes
theevidenceisinconclusive.

Still,itisimportantforinvestors,directors,andregulatorsto
understandthedatasotheycanmakeinformeddecisions.
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Summary
Whatiscorporatefinancialmanagement?
Investmentdecision
Financingdecision
Workingcapitalmanagement

Whatisthegoaloffinancialmanagement?
Maximizeshareholderwealth

Whatarethethreemajorformsofbusinessorganization?
Soleproprietorship
Partnership
Corporation

Whataretheinteractionsbetweenfirmandstakeholders?

Stockholders
Bondholders
Financialmarket
Society

Whatiscorporategovernance?

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