Introduction To

Financial
Management
Chapter 1

Topics
1.

2.
3.
4.

The basics of corporate financial

management decisions and the role of
the financial manager
The goal of corporate financial
management
The financial implications of the different
forms of business organizations
The conflicts of interest that can arise
between managers and owners
2

The Basics Of Corporate

Financial Management
Define Asset:
Decisions

Examples: Cash, UPS Trucks, Buildings

Provide probable future economic benefit

Definition of Finance:

How to allocate scarce resources across

assets over time in order to earn a return
What should we invest in?
Should we incur debt?

How do we as individuals make

investments, conduct banking activities,
incur debt?
3

The Basics Of Corporate

Financial Management
Decisions
Four basic areas of finance:

Corporate finance

Investments

Stocks and Bonds, Risk and Return

Financial institutions

How corporations allocate scarce resources

across assets over time

Banks, Exchanges, Insurance Co.

International Finance

All of the above but more than one country

4

Why do you need to know

finance?

Student Loans
Credit cards
Investments
Retirement
Savings
Banking

Careers in:

Finance
Accounting
Marketing
Sole proprietorship
Security Analyst

Why Study Finance?

Marketing

Accounting

Dual accounting and finance function,

preparation of financial statements

Management

Budgets, marketing research, marketing

financial products

Strategic thinking, job performance, profitability

Personal finance

Budgeting, retirement planning, college

planning, day-to-day cash flow issues

The Role Of The Financial

Manager

Business Finance Questions

1. What

make

long-term investments should you

Examples: equipment, buildings

2. Where

will you get the long-term

financing?

Profits? Equity? Debt?

3. Short-term

cash management

1. How

will you collect from customers and

pay your bills?
7

Financial Management
Decisions
1.

Capital Budgeting

The process of planning and managing a

firms long-term investments

2.

Capital Structure

3.

Evaluating the size, timing, and risk of the

future cash flows
Use NPV finance tool to decide (chapter 8)

The mixture of debt and equity

Working Capital

The firms short-term assets and liabilities

8

The Role Of The Financial

Manager

Forms of Business
Organization

Three major forms in the united

states
Sole proprietorship
Partnership

General
Limited

Corporation
S-Corp
Limited liability company

10

Sole Proprietorship
Advantages
Easiest

to start
Least regulated
Single owner keeps
all the profits
Taxed once as
personal income

Disadvantages
Limited

to life of

owner
Equity capital
limited to owners
personal wealth
Unlimited liability
Difficult to sell
ownership interest

11

Partnership
Advantages
Two

or more
owners
More capital
available
Relatively easy to
start
Income taxed once
as personal income

Disadvantages
Unlimited

liability

General partnership
Limited partnership

Partnership

dissolves when one

partner dies or
wishes to sell
Difficult to transfer
ownership

12

Corporation
Advantages
Limited

liability
Unlimited life
Separation of
ownership and
management
Transfer of
ownership is easy
Easier to raise
capital

Disadvantages
Separation

of
ownership and
management
(agency problem)
Double taxation
(income taxed at
the corporate rate
and then dividends
taxed at personal
rate)
13

Figure 1.2

14

Forms of Business
Organization
Sole proprietorships
Partnerships
Corporations

Fewest in number
Account for more business transactions
than the other two types combined

Limited Liability Company (LLC)

Benefit of single taxation and limited

liability
15

Forms of Business
Organization

Sole Proprietorship (one person)

Easy to set up
No double taxation
No liability insulation to deflect outside
claims (unlimited liability)
When owner dies, business ends
Difficult to transfer ownership
Hard to raise capital (money to invest)

Partnerships (More than one person)

General partners fully liable

16

Forms of Business
Organization

Corporations

Legal person separate from owners

Can owe property, sue, be sued, enter into
contracts
Limited Liability (owners only lose up to
investment, debt responsibility of corp.)
Continuity of existence (Stock transferable
when owner dies, corporation does not die)
Separation of owner and manager
Allows continual existence, however it
creates agency problem
Easier to get external financing (equity & debt)
Double taxation

17

Corporations

Issue stock to stockholders

Issue bonds to bondholders
Carry out business activities for the
purpose of making profits

Not-for-profit corporations carry out

charitable, educational, or other philanthropic
purposes and are beyond the scope of this
chapter

Distribute the profits to their owners

Pay interest to bondholders
Reinvests earnings to buy more assets
18

The Financial Implications Of The

Different Forms Of Business
Organizations
The corporate form is superior when it comes to
raising cash:

Ease of transferring ownership

Business does not end each time stock is sold
Unlimited life
When owners die, the business does not end
Limited liability for business debts
Owners can only loose up to the amount they have
invested

For good ideas to be implemented which in turn

creates profits for owners, cash is required. Thus
the business form which can raise cash more
easily is more beneficial
24

Page 10 In Textbook
Link to:
www.buisnessfinancemag.com
Is filled with ads

Better to go to www.Google.com
and click on News

25

The Goal Of Corporate

Financial Management

26

The Goal Of Corporate

Financial Management

Presume:

The stockholders elect the BofD

The BofD hire the managers
The managers work for the stockholders

Goal:

The financial managers have a fiduciary duty

to identify goods and services that add value
to the firm because they are desired and
valued in the free marketplace, which in turn
increases current and future revenues, which
in turn increases stock price/equity value
27

The Goal Of Corporate

Financial Management

The goal of financial management is to

maximize the current value per share of
existing stock (market value of equity)

This is theoretically a good goal

Do some managers employ creative accounting

so that it looks like stock value goes up?

Financial managers should not take illegal

or unethical actions to increase stock
value

28

The Goal Of Corporate

Financial Management
1.

Managers commit assets in a

particular direction in order to earn
a return
1.

Capital budgeting using NPV model

(ch.9)

2.

Cash Flow is what the managers will

use to make decisions (ch.5)

Goal is to maximize returns at a given

risk level (risk and return are
considered together) (ch.11)
29

The Goal Of Corporate

Financial Management
2.

Corporation must continually get

cash to acquire assets to earn a
return
1.

2.
3.

Corporation acquires cash from

financial markets through equity or
debt
Corporation reinvests earnings
(remaining amount paid to owners)
More assets, more sales, higher
return, higher stock value
(theoretically)
30

The Goal Of Corporate

Financial Management
3.

All this is done to increase the

current stock price
1.
2.

Owners stock value is increased

Managers salaries should be based on
stock value and so their salaries increase
(theoretically)

31

Goal Of Financial
Management

What should be the goal of a corporation?

Maximize profit?
Minimize costs?
Maximize market share?
Maximize the current value of the companys
stock?

Does this mean we should do anything and

everything to maximize owner wealth?
Sarbanes-Oxley Act

Makes managers personally responsible for

financial statements

32

The Conflicts Of Interest That

Can Arise Between Managers
Creative
accounting so that it looks like
And
Owners
stock value goes up?

Enron:

World Com:

Former Enron CFO Andrew Fastow, the alleged

mastermind behind Enron's complex network of offshore
partnerships and questionable accounting practices*
Former CEO, Bernard Ebbers was convicted (2005) of
fraud and conspiracy in the largest (to date) accounting
scandal in U.S. history, as a result of WorldCom's false
financial reporting, and subsequent 11 billion dollar loss
to investors*
*Wikipedia

Andrew and Bernard were agents that were

supposed to be serving the stockholders

33

Agency Problem

How do you get managers inside the firm

(managers have custody of assets that belong
to owners) to act in the best interest of the
owners?

We must incur agency costs to minimize problems

34

Agency Costs

Direct

Pay managers based on stock value (aligns

managers and owners interests)
Allow external auditor to examine the financial
statements
Have internal controls over assets and
accounting
Have internal auditors report to BofD
Sarbanes-Oxley Act
Makes managers personally responsible for
financial statements
35

Agency Costs

Indirect

A profitable project that is risky may benefit

owners, but may put the managers job at risk
If manager does not take on project Cost
to owner
Managers may create ways to pay themselves
great deals of money (accounting or other)
Cost to owner

36

Financial Markets

Primary Markets
Original sale of equity or debt
Corporation issues security

Secondary Markets
After original sale of equity or debt
You sell/buy security

37

Financial Markets

Secondary Markets:
Dealer Markets (Over-the-counter markets
(OTC))

Dealers buy and sell for themselves

(think of car lot)

Most debt is sold this way

Example: NASDAQ

Auction Markets (Exchanges)

Brokers and agents match buyers and sellers

(think of real estate agent)

Most of the large firms equity is sold this way

Example: NYSE
38

Summary Slide

The Basics Of Corporate Financial Management

Decisions
Why do you need to know finance?
The Role Of The Financial Manager
Financial Management Decisions
Forms of Business Organization
The Financial Implications Of The Different Forms Of
Business Organizations
The Goal Of Corporate Financial Management
The Conflicts Of Interest That Can Arise Between
Managers And Owners
Agency Problem
Agency Costs
Financial Markets
39