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Chapter 01 Introduction toFinancial Management

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

What is Finance?

• Finance applies specific value to– things owned– services used– decisions made

• Financial management– organization’s approach to valuation

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Economic Participants• Two dimensions

– Participants with “extra” investment money – Participants with economically viable ideas

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• Type 1 Participants

– Do not lend or spend in business context

– No direct role in financial markets

– Indirect role: to provide labor and consume products

Economic Participants

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• Type 4 Participants

– Use financial tools

• evaluate own businesses

• choose highest-potential ideas

– Are self-funded, so no need for financial markets

Economic Participants

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• Types 2 and 3 Participants– use financial institutions and financial markets for

mutually beneficial exchange

• Type 2: makes temporary loans to Type 3

• Type 3: typically consists of companies engaging in

R & D

Economic Participants

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Where Does the Cash Go?• Economically successful projects repay money

(plus profit) to investors• Friction occurs when not all cash is returned

to investors - Retained Earnings - Taxes

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Figure 1.4

Complete Cash Flows of Finance

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Subareas of Finance

• Investments – involves methods and techniques for making

decisions about what kinds of securities to own

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Subareas of Finance

• Financial management

– Decisions about acquiring and using cash

– Examples include

• Organizing and raising capital

• Tax decisions

• Projects to fund

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Subareas of Finance

• Financial institutions and markets– Facilitate flow of capital between investors and companies

• International finance– Finance theory used in global business environment

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Financial Decision Application & Theory

• Risk – Uncertainty of future cash flows due to timing and

size• Financial Asset

– Ownership in cash flow represented by securities like stocks, bonds, and other assets

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• Real Assets – Physical property like gold, machinery, equipment,

real estate• Real Markets

– Places/processes that facilitate real asset trading• Time Value of Money (TVM)

– Theory and application of valuing cash flows at various points in time

Financial DecisionApplication & Theory

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Finance vs. Accounting

• Accounting– tracks what happened to firm’s money in the past

• Financial Management– combines historical figures and current

information– determines what should happen with firm’s

money now and in the future

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The Financial Manager

• Chief Financial Officer– Highest level financial officer

• Controller– Oversees accounting function

• Treasurer– Responsible for managing cash, credit, financing, capital

budgeting, risk management

CFO

Controller Treasurer

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Finance in Other Business Functions• CFO and Treasurer

– most visible finance-related positions• Finance permeates the organization

• Used to develop and manage strategy• Used in day-to-day business operations

– Operations– Marketing– Human Resources

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Finance in Your Personal Life• Help you make good personal financial

decisions– Borrowing money for a new car– Refinancing home mortgage at lower rate– Making credit card or student loan payments– Saving for retirement

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Business Organization• Single owners, partners, and corporations

operate businesses

• Advantages and disadvantages related to• Controls and ownership of firm• Owners’ risks• Access to capital and tax ramifications

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Business Form Types

• Sole Proprietorships

• General Partnerships

• Corporations

• Hybrids

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Sole Proprietorships• Not legally separate from the owner

– Advantages• Easy to start• Light regulatory and paperwork burden• Single taxation at the personal tax rate

– Disadvantages• Unlimited liability• Limited access to capital

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General Partnerships• Partners own the business together

– Advantages• Relatively easy to start• Single taxation

– Disadvantages• Partners jointly share unlimited liability• Personally liable for legal actions and debts of firm• Difficult to raise large amounts of capital

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Public Corporations• Legally independent entity entirely separate

from its owners– Advantages

• Limited liability for owners• Can raise large amounts of capital• Easy to transfer ownership

– Disadvantages• Double taxation (corporate level and personal level)

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Hybrid Organizations• Combine attributes of several forms

– Advantages• Offer single taxation and limited liability to all

owners– S Corporations– Limited Liability Partnerships (LLPs)– Limited Liability Companies (LLCs)

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Firm Goals• Owner seeks to maximize shareholder wealth

and company’s value through– Maximizing present value of future cash flows– Maximizing owners’ equity – Decisions about

• attracting additional funds • projects in which to invest• returning profits to owners over time

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• Maximize value of owners’ equity– Increase current value per share (stock price) of

existing shares• Common methods

– Maximize net income or profit– Minimize costs– Maximize market share

Corporate Goals

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Agency Theory

• Problems arise when principal (shareholder) hires agent (manager) to operate firm but cannot monitor the agent’s actions

• Manager’s interest may not be aligned with shareholder goals

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• Three approaches to minimizing this conflict of interest– Ignore if effect is minimal– Use accountants, debt holders to monitor managers– Provide incentives to managers

• Equity stakes• Stock options• Employee Stock Option Plan (ESOP)

Agency Theory

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Corporate Governance

• Set of laws, policies, incentives, and monitors designed to handle issues arising from the separation of ownership and control

• Current CG Issues– http://www.business-standard.com/article/companies/murty-s-elevation-may

-raise-corporate-governance-issues-at-infy-113082600671_1.html

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• Inside monitors– Board of Directors

• Hires the CEO• Evaluates management• Designs compensation plans

Corporate Governance

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• Outside monitors• Auditors• Analysts• Banks• Credit rating agencies

Corporate Governance

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Corporate Governance Monitors

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Ethics• Financial professionals manage other people’s

money– Corporate managers– Bankers– Investment advisors

• Ethical dilemmas of corporate agency relationship– Stealing from firms = stealing from shareholders

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Financial Markets and Intermediaries• Financial markets and financial intermediaries

– Facilitate flow of capital from investors to firms and back to investors

– Earn very high profits because of specialized expertise and assets

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Financial Institution Cash Flows

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The Financial Crisis

• Subprime Mortgage Borrowers– Higher-risk borrowers charged higher interest

rates due to higher risk of default• Securitization

– Loan originators sell the loan repayment rights to other financial institutions or investors

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• http://www.nytimes.com/2009/12/24/business/24trading.html?pagewanted=all

• Sparked by collapse of U.S. home prices in late 2006 and 2007

• Spread to other financial institutions via affected mortgage-backed securities

• Resulted in credit tightening by financial institutions; loss of confidence by consumers

The Financial Crisis

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Financial Crisis Overview

• http://www.youtube.com/watch?v=_xIO731MAO4

• http://www.youtube.com/watch?v=qqUGoVez8xg