Chapter 1 - An Introduction to

Financial Management

 2005, Pearson Prentice Hall

 Finance
 The art and science of managing
money
 Financial Management
 Is concerned with the maintenance
and creation of economic value or
wealth
 Goal of the Firm

1) Profit Maximization?
this goal ignores:
a) TIMING of Returns
(Time Value of Money - Ch. 5)
b) UNCERTAINTY of Returns
(Risk - Ch. 6)
 Goal of the Firm

2) Shareholder Wealth
Maximization?
this is the same as:
a) Maximizing Firm Value
b) Maximizing Stock Price
 Legal Forms of Business
1) Sole Proprietorship
 A business owned by a single individual and that
has a minimum amount of legal structure
 Advantages:
 Easily established with few complications
 Minimal organizational costs
 Does not have to share profits or control with others
 Disadvantages:
 Unlimited liability of the owner
 Owner must absorb all losses
 Equity capital limited to the owner’s personal
investment
 Business terminates immediately upon death of owner
 Legal Forms of Business

2) Partnership
 An association of two or more
individuals joining together as co-
owners to operate a business for
profit.
 Legal Forms of Business

2a) General Partnership

 Relationship between partners I dictated
by the partnership agreement
 Advantages:
 Minimal organizational requirements
 Disadvantages
 All partners have unlimited liability
 Difficult to raise large amounts of capital
 Partnership dissolved by the death or
withdrawal of general partner
 Legal Forms of Business
2b) Limited Partnership
 Consists of at least one general partner and one or more
limited partners (investors)
 Advantages:
 For limited partners, liability limited to the amount of capital
invested in the company
 Withdrawal or death of a limited partner does not affect
continuity of the business
 Stronger inducement in raising capital
 Disadvantages:
 For general partners, they have unlimited liability in the
partnership
 Names of limited partners may not appear in the name of the firm
 Limited partners may not participate in the management of the
business
 More expensive to organize than general partnership, as written
agreement is mandatory
 Legal Forms of Business

2c) Limited Liability Company

(LLC)
 Cross between a partnership and a
corporation.
 Owners have limited liability, but the
firm runs and is taxed like a
partnership.
 Legal Forms of Business
3) Corporation
 A business entity having the power to purchase,
sell, and own assets and to incur liabilities while
existing separately and apart from its owners.
 Advantages:
 Limited liability of owners
 Ease of transferability, i.e., by the sale of one’s shares
of stock
 Death of an owner does not result in the discontinuity of
the firm’s life
 Ability to raise large amounts of capital is increased
 Disadvantages:
 Most difficult and expensive form of business to
establish
 Control of corporation not guaranteed by partial
ownership of stock.
 Role of the Financial
Manager in a Corporation
Vice President for Finance, also called
th Chief Financial Officer (CFO)
 Serves under the corporation’s CEO and is
responsible for overseeing financial
planning, corporate strategic planning,
and controlling the firm’s cash flow
 Treasurer and controller serve under the
CFO.
 Role of the Financial
Manager in a Corporation
Treasurer
 Handles the firm’s financial activities,
including cash and credit
management, making capital
expenditure decisions, raising funds,
financial planning, and managing any
foreign currency received by the firm
 Role of the Financial
Manager in a Corporation
Controller
 Responsible for managing the firm’s
accounting duties, including
producing financial statements, cost
accounting, paying taxes, and
gathering and monitoring the data
necessary to oversee
 The Corporation and
Financial Markets

Corporation Investors

Government
 The Corporation and
Financial Markets

Corporation cash Investors

Raising capital
securities

Government
 The Corporation and
Financial Markets

Corporation cash Investors

Raising capital
securities

Secondary
markets

Government
 The Corporation and
Financial Markets
Corporation cash Investors
Raising capital
securities
reinvest
Secondary
markets
dividends,
Cash flow
int., etc.

tax

Government
 The Corporation and
Financial Markets
 Primary Market
 Market in which new issues of a
security are sold to initial
buyers.
 Secondary Market
 Market in which previously
issued securities are traded.
 The Corporation and
Financial Markets
 Initial Public Offering (IPO)
 The first time the firm’s stock is
sold to the general public.
 Seasoned New Issue
 A new stock offering by a firm
that already has stock that is
traded in the secondary market.
Ten Principles of Financial Management

Principle 1:
Risk-return tradeoff - we won't take
additional risk unless we expect to be
compensated with additional return.
Ten Principles of Financial Management

Principle 2:
Time value of money - a dollar received
today is worth more than a dollar received
in the future.
Ten Principles of Financial Management

Principle 3:
Cash -- Not Profits -- is King
- In measuring value we will use cash flows
rather than accounting profits because it
is only cash flows that the firm receives
and is able to reinvest.
Ten Principles of Financial Management

Principle 4:
Incremental cash flows count - In making
business decisions we will only concern
ourselves with what happens as a result
of that decision.
Ten Principles of Financial Management

Principle 5:
The curse of competitive markets
- In competitive markets, extremely large profits
cannot exist for very long because of
competition moving in to exploit those large
profits. As a result, profitable projects can only
be found if the market is made less competitive,
either through product differentiation or by
achieving a cost advantage.
Ten Principles of Financial Management

Principle 6:
Efficient Capital Markets
- The markets are quick and the prices are
right.
Ten Principles of Financial Management

Principle 7:
The agency problem - managers won't
work for the owners unless it's in their
best interest. The agency problem is a
result of the separation between the
decision makers and the owners of the
firm. As a result managers may make
decisions that are not in line with the goal
of maximization of shareholder wealth.
Ten Principles of Financial Management

Principle 8:
Taxes bias business decisions.
Ten Principles of Financial Management

Principle 9:
All risk is not equal - since some risk can
be diversified away and some cannot.
The process of diversification can reduce
risk, and as a result, measuring a
project’s or an asset's risk is very
difficult.
Ten Principles of Financial Management

Principle 10:
Ethical dilemmas are everywhere in finance.
 Ethical behavior is doing the right thing, and it
is important in financial management, just as
it is important in everything we do.
Unfortunately, precisely how we define what
is and what is not ethical behavior is
sometimes difficult. Nevertheless, we should
not give up the quest.