Professional Documents
Culture Documents
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Chapter
McGraw -Hill/Irwin
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Defining Finance
Im thinking about starting a new business
will it reward me adequately?
Finance is the study of how people allocate scarce resources over time
costs and benefits are distributed over time but the actual timing and size of future cash flows are often known only probabilistically
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These concepts and models apply at all levels and scales of decision making
Financial Management
Financial Management or business finance is concerned with managing an entitys money. For example, a company must decide:
where to invest its money. whether or not to replace an old asset. when to issue new stocks and bonds. whether or not to pay dividends.
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New financial products with a focus on hedging are being widely used.
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Risk-Return Trade-Off
Influences operational side (capital versus labor/ Product A versus Product B) Influences financial mix (stocks versus bonds versus retained earnings)
- Stocks are more profitable but riskier. - Savings accounts are less profitable and less risky (or safer)
Sole Proprietorship
Represents single-person ownership Advantages:
Simplicity of decision-making. Low organizational and operational costs.
Partnership
Similar to sole proprietorship except there are two or more owners.
Articles of partnership: Specifies ownership interest, the methods for distributing profits, and the means of withdrawing from the partnership. Limited partnership: One or more partners are designated as general partners and have unlimited liability of the debts of the firm; other partners designated limited partners and are liable only for their initial contribution.
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Drawback
Unlimited liability to the owner. Profits and losses are taxed as though they belong to the individual owner.
Corporation
Corporation
- Articles of incorporation: Specify the rights and limitations of the entity. - Its owned by shareholders who enjoy the privilege of limited liability. - Has a continual life.
Corporation (contd)
Disadvantage:
The potential of double taxation of earnings.
Subchapter S corporation: Income is taxed as a direct income to stockholders and thus is taxed only once as normal income.
- Key feature is the easy divisibility of ownership interest by issuing shares of stock.
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conflict of interest
There may be some conflict of interest between managers and the owners. Suppose you have to decide between two alternative investments: Safe ( With lower expected return) or Risky ( with higher expected return)? Which one to go for?
Some owners may want safe, but if they want safe, they can pull out their shares and put in safe assets. If risky investment makes to increase the market value of the fi rm, you should go for the risky one.
Management rule:
Maximize the wealth of current shareholders
Rule depends only upon production technology, market interest rates, market risk premiums, and security prices Alternative rules stated in terms of profit maximization are fraught with unresolved issues, and are better avoided
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Profit
One of the most critical roles of the board of directors is to create incentives that make it in the CEOs best interests. Conceptually this is not a difficult challenge. Some combination of three basic policies will create the right monetary incentives for CEOs to maximize the values of their companies:
Boards can require that CEOs become substantial owners of company stock. Salaries, bonuses, and stock options can be structured so as to provide big rewards for superior performance and big penalties for poor performance. The threat of dismissal for poor performance can be made real
What is the meaning of choosing investment that maximizes profit? Why managers have to act for the interest of shareholders?
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Social Responsibility
Adoption of policies that maximize values in the market attracts capital, provides employment and offers benefits to the society. Certain cost-increasing activities may have to be mandatory rather than voluntary initially, to ensure burden falls equally over all business firms.
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Ethical Behavior
Ethical behavior creates invaluable reputation. Insider trading Protected against by the Securities and Exchange Commission (SEC).
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Capital markets
- Long-term markets - Securities include common stock, preferred stock and corporate and government bonds.
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Allocation of Capital
Primary market
When a corporation uses the financial markets to raise new funds, the sale of securities is made by way of a new issue.
Secondary market
When the securities are sold to the public (institutions and individuals). Financial managers are given a feedback about their firms performance.
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Restructuring
Restructuring can result in:
Changes in the capital structure (liabilities and equity on the balance sheet). Selling of low -profit-margin divisions with the proceeds of the sale reinvested in better investment opportunities. Removal or large reductions in the of current management team.