Chapter 1 – An Introduction to Financial Management

Keown, Martin, Petty, and Scott

What is Finance

Financial Management is concerned with the maintenance and creation of wealth.

Finance focuses on decision making with an eye towards creating wealth.

What is Finance

As such finance deal with decisions such as

1. When to introduce a new product

2. When to invest in new assets

3. When to replace existing assets

4. When to borrow from banks

5. When to issue stocks and bonds

6. When to extend credit to a customer, and

7. How much cash to be maintained.

Goal of a firm

Profit maximization vs. maximization of shareholder wealth

The timeline for profit maximization affects the outcome.

Financial managers’ decisions must take into account the risk and returns of each project, as well as the timing of the returns.

Goal of a firm

Profit maximization goal is unclear about the time frame over which profits are to be measured.

It is easy to manipulate the profits through various accounting policies.

Profit maximization goal ignores risk and timing of cash flows.

Goal of a firm

Maximization of shareholder wealth

Modifies the profit maximization goal to incorporate uncertainty and risk.

Decisions are made based upon what should happen to the stock price if everything else were held constant.

Legal Forms of Business Organization Sole proprietorship

Owned by an individual with full rights to profits and responsible for all liabilities. Unlimited liability.

Initiated simply by starting business operations.

Termination occurs by owner’s choice or death.

Legal Forms of Business Organization Partnership

Two or more people acting as co-owners to operate a business for profit.

Two types of partnership: General or Limited

General Partnership

General Partnership – each partner is fully responsible for liabilities.

Limited Partnership

Limited Partnership – one or more partners have

liability limited to the amount of capital invested.

One or more partners can have limited liability

There must be at least one general partner with unlimited liability.

Limited partners cannot participate in the management of the business and their names cannot appear in the name of the firm.

Legal Forms of Business Organization Corporation – an entity that legally functions

separately and apart from its owners

Owners of the corporation hold shares of common stock that are transferable.

Liability is limited to the amount of investment in the company’s common stock.

Corporations continue even with transfer of shares or death of owners.

Comparison of Organizational FormsLarge growing firms choose the corporate form

Benefits: Limited liability Easy to transfer ownership Unlimited life (unless the firm goes through corporate

restructuring such as mergers and bankruptcies)

Drawbacks: No secrecy of information Maybe delays in decision making Greater regulation Double taxation

Other forms of organization

S-Type Corporations Benefits

Limited liability Taxed as partnership

Limitations Owners must be people Can’t be used for joint ventures between two

corporations

Other forms of organization

Limited Liability Corporations Benefits

Limited liability Taxed like a partnership

Limitations Qualifications vary from state to state Can’t appear like corporation otherwise will be

taxed like one

The Role of the Financial Manager in a Corporation

Principle 1: The Risk-Return Trade-off

Would you invest your savings in the stock market if it offered the same expected return as your bank?

We won’t take on additional risk unless we expect to be compensated with additional return.

Higher the risk of an investment, higher will be its expected return.

The Risk-Return Trade-off

Principle 2: The Time Value of Money

A dollar received today is worth more than a dollar to be received in the future.

Because we can earn interest on money received today, it is better to receive money earlier rather than later.

Principle 3: Cash—Not Profits—Is King In measuring wealth or value, we use cash

Flow, not accounting profit, as our measurement tool.

Cash flows are actually received by the firm and can be reinvested. On the other hand, profits are recorded when they are earned rather than when money is actually received.

It is possible for a firm to show profits on the books but have no cash!

Principle 4: Incremental Cash Flows

The incremental cash flow is the difference between the projected cash flows if the project is selected, versus what they will be, if the project is not selected.

This difference reflects the true impact of a decision.

Principle 5: The Curse of Competitive Markets

It is hard to find exceptionally profitable projects.

If an industry is generating large profits, new entrants are usually attracted. The additional competition and added capacity can result in profits being driven down to the required rate of return.

Product Differentiation (through Service, Quality) and cost advantages (through economies of Scale) can insulate products from competition.

Principle 6: Efficient Capital Markets

The values of securities at any instant in time fully reflect all publicly available information.

Prices reflect value and are right.

Price changes reflect changes in expected cash flows (and not cosmetic changes such as accounting policy changes). Good decisions drive up the stock prices and vice versa.

Principle 7: The Agency Problem

The separation of management and the ownership of the firm creates an agency problem. Managers may make decisions that are not in line

with the goal of maximization of shareholder wealth.

Agency conflict reduced through monitoring (ex. Annual reports), compensation schemes (ex. stock options), and market mechanisms (ex. Takeovers).

Principle 8: Taxes Bias Business Decisions

The cash flows we consider for decision making are the after-tax incremental cash flows to the firm as a whole.

Principle 9: All Risk is Not Equal

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. A project’s risk changes depending on whether you measure it standing alone or together with other projects the company may take on.

All Risk is Not Equal

Principle10: Ethical Behavior Is Doing the Right Thing, and Ethical Dilemmas Are Everywhere in Finance

Ethical dilemma — Each person has his or her own set of values, which forms the basis for personal judgments about what is the right thing.

Ethics are relevant in business and unethical decisions can destroy shareholder wealth (ex. Enron Scandal).