ACCOUNTANT’S GUIDE TO FINANCIAL MANAGEMENT Delta Publishing Company i Copyright 2008 by DELTA PUBLISHING COMPANY P.O. Box 5332, Los Alamitos, CA 90721-5332 All rights reserved. No part of this course may be reproduced in any form or by any means, without permission in writing from the publisher. ii PREFACE Accountant’s Guide to Financial Management is designed for the accountants who must have financial knowledge but has not had formal training in finance. The goals of the course are fourfold: 1. It provides an understanding and working knowledge of the fundamentals of finance that can be put to practical application in day-to-day jobs of managers. 2. It also concentrates on providing a working vocabulary for communication. 3. It uses the solved problems approach, with emphasis on the practical application of financial concepts, tools, and methodology. 4. It incorporates computer software demonstration and printouts. The course also includes checklists, guidelines, rules of thumb, diagrams, graphs, and tables to aid your comprehension of the subjects discussed. iii TABLE OF CONTENTS Chapter 1 An Overview of Financial Management Chapter 2 Financial Statements and Cash Flow Chapter 3 Evaluating a Firm's Financial Performance Chapter 4 Improving Financial Performance Chapter 5 Budgeting, Planning, and Financial Forecasting Chapter 6 The Time Value of Money Chapter 7 The Meaning and Measurement of Risk and Rates of Return Chapter 8 Valuation of Stocks and Bonds Chapter 9 The Cost of Capital Chapter 10 Capital Budgeting: Techniques and Practice Chapter 11 Determining the Financing Mix Chapter 12 Managing Liquid Assets Chapter 13 Short-Term Financing Chapter 14 Debt Financing Chapter 15 Equity Financing Chapter 16 International Finance Glossary iv CHAPTER 1 AN OVERVIEW OF FINANCIAL MANAGEMENT LEARNING OBJECTIVES After reading this chapter, you should be able to: Identify the goal of the firm. Distinguish between profit maximization and stockholder wealth maximization. Explain how agency problems may interfere with the goal of stockholder wealth maximization. Describe the scope and role of finance. Summarize the language and decision making of finance. Explain the role of financial managers. Describe the relationship between accounting and finance. Explain the financial and operating environment in which financial managers operate. Compare the various legal forms of business organization. Financial management is the process of planning decisions in order to maximize the shareholders‘ wealth (or the firm's market value). Financial managers have a major role in cash management, the acquisition of funds, and in all aspects of raising and allocating financial capital, and taking into account the trade-off between risk and return. Financial managers need accounting and financial information to carry out their responsibilities. OBJECTIVES OF MANAGERIAL FINANCE Company goals usually include (1) stockholder wealth maximization, (2) profit maximization, (3) managerial reward maximization, (4) behavioral goals, and (5) social responsibility. Modern managerial finance theory operates on the assumption that the primary goal of the business is to maximize the wealth of its stockholders, which translates into maximizing the price of the firm‘s common stock. The other goals mentioned above also influence the company‘s policy but are less important than stock price maximization. Note that the traditional goal frequently stressed by economists--profit maximization--is not sufficient for most companies today. PROFIT MAXIMIZATION VS. STOCKHOLDER WEALTH MAXIMIZATION Profit maximization is basically is a single-period or, at most, a short-term goal, to be achieved within one year; it is usually interpreted to mean the maximization of profits within a given period of time. A corporation may maximize its short-term profits at the expense of its long-term profitability. In contrast, stockholder wealth maximization is a long-term goal, since stockholders are interested in future as well as present profits. Wealth maximization is generally preferred because it considers (1) wealth for the long term, (2) risk or uncertainty, (3) the timing of returns, and (4) the stockholders‘ return. Timing of returns is important; the earlier the return is received, the better, since a quick return reduces the uncertainty about receiving the return, and the money received can be 1 reinvested sooner. Table 1-1 summarizes the advantages and disadvantages of these two often conflicting goals. TABLE 1-1 PROFIT MAXIMIZATION VERSUS STOCKHOLDER WEALTH MAXIMIZATION Goal Objective Advantages Disadvantages Profit Large profits 1. Easy to calculate profits. 1. Emphasizes the short maximization 2. Easy to determine the term. link between financial 2. Ignores risk or decisions and profits. uncertainty. 3. Ignores the timing of returns. 4. Requires immediate resources. Stockholder Highest share 1. Emphasizes the long 1. Offers no clear wealth price of term. relationship between maximization common 2. Recognizes risk or financial decisions and stock uncertainty. stock price. 3. Recognizes the timing of 2. Can lead to management returns. anxiety and frustration. 4. Considers stockholders‘ 3. Can promote aggressive return. and creative accounting practices Note: The policy decisions that by themselves are likely to affect the value of the firm (maximize stockholder wealth) include the: Investment in a project with a large net present value. Sale of a risky division that will now increase the credit rating of the entire company. Use of a more highly leveraged capital structure that resulted in lower cost of capital. Let us now see how profit maximization may affect wealth maximization. EXAMPLE 1-1 Profit maximization can be achieved in the short term at the expense of the long-term goal of wealth maximization. For example, a costly investment may create losses in the short term but yield substantial profits in the long term; a company that wants to show a short-term profit may postpone major repairs or replacement even though such postponement is likely to hurt its long- term profitability. EXAMPLE 1-2 2 Profit maximization, unlike wealth maximization, does not consider risk or uncertainty. Consider two products, A and B, and their projected earnings over the next five years, as shown below. Year Product A Product B 1 $20,000 $22,000 2 $20,000 $22,000 3 $20,000 $22,000 4 $20,000 $22,000 5 $20,000 $22,000 $100,000 $110,000 A profit maximization approach favors product B over product A because its totals projected earnings after five years are higher. However, if product B is more risky than product A, then the decision is not as straightforward as the figures seem to indicate because of the trade-off between risk and return. Stockholders expect greater returns from investments with higher risk; they will demand a sufficiently large return to compensate for the comparatively greater level of risk of producing product B. AGENCY PROBLEMS Even though the goal of the firm is the maximization of shareholder wealth, the agency problem may interfere with the implementation of this goal. For example, managers will not work for the owners unless it is in their best interest. Major agency problems develop (1) between owners and managers and (2) between creditors and owners. Shareholders versus Managers The agency problem arises when a manager owns less than 100 percent of the company‘s ownership. As a result of the separation between the managers and owners, managers may make decisions that are not in line with the goal of maximizing stockholder wealth. For example, they may work less eagerly and benefit themselves in terms of salary and perks. The costs associated with the agency problem, such as a reduced stock price and various "perks", is called agency costs. Several mechanisms are used to ensure that managers act in the best interests of the shareholders: (1) golden parachutes or severance contracts, (2) performance-based stock option plans, and (3) the threat of takeover. Creditors versus Shareholders Conflicts develop if (1) managers, acting in the interest of it shareholders, take on projects with greater risk than creditors anticipated and (2) raise the debt level higher than was expected. These actions tend to reduce the value of the debt outstanding. FINANCE DECISIONS AND RISK-RETURN TRADE-OFF The concept of risk-return trade-off is integral to the theory of finance. We will not bear additional risk unless we expect to be compensated with additional return. Figure 1-1 illustrates this tradeoff. 3 FIGURE 1-1 RISK-RETURN FUNCTION Risk refers to the variability of expected returns (sales, earnings, or cash flow) and is the probability that a financial problem will affect the company ‗s operational performance or financial position. Typical forms of risk are economic risk, political uncertainties, and industry problems. Risk analysis is a process of measuring and analyzing the risk associated with the financial and investment decisions. It is important to consider risk in making capital investment decisions because of the large amount of capital involved and the long-term nature of the investments. Analysts must also consider the rate of return in relation to the degree of risk involved. (Return, the reward for investing, consists of current income, in the form of either periodic cash payments or capital gain (or loss) from appreciation (or depreciation) in market value.) Proper assessment and balance of the various risk-return trade-off is available is part of creating a sound stockholder wealth maximization plan. The risk-return trade-off is discussed in chapters 7, 10, and 12. PORTFOLIO RISK AND RETURN Not all risk is created equal. Some risk can be diversified away, and some cannot. There is an old saying, "don't put all your eggs in one basket." As we will see for most securities and projects, some risk can be reduced or eliminated through diversification. We will discuss this issue and how to measure portfolio return and risk in Chapter 7. TIME VALUE OF MONEY Today‘s dollars are not the same as tomorrow‘s.